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91–038 PDF 2004

S. Hrg. 108–368

MUTUAL FUNDS: TRADING PRACTICES AND

ABUSES THAT HARM INVESTORS

HEARING

BEFORE THE

FINANCIAL MANAGEMENT, THE BUDGET, AND 

INTERNATIONAL SECURITY SUBCOMMITTEE

OF THE

COMMITTEE ON 

GOVERNMENTAL AFFAIRS 

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

NOVEMBER 3, 2003

Printed for the use of the Committee on Governmental Affairs

(

(II)

COMMITTEE ON GOVERNMENTAL AFFAIRS 

SUSAN M. COLLINS, Maine, Chairman 

TED STEVENS, Alaska 

GEORGE V. VOINOVICH, Ohio 

NORM COLEMAN, Minnesota 

ARLEN SPECTER, Pennsylvania 

ROBERT F. BENNETT, Utah 

PETER G. FITZGERALD, Illinois 

JOHN E. SUNUNU, New Hampshire 

RICHARD C. SHELBY, Alabama 

JOSEPH I. LIEBERMAN, Connecticut 

CARL LEVIN, Michigan 

DANIEL K. AKAKA, Hawaii 

RICHARD J. DURBIN, Illinois 

THOMAS R. CARPER, Delaware 

MARK DAYTON, Minnesota 

FRANK LAUTENBERG, New Jersey 

MARK PRYOR, Arkansas

MICHAEL D. BOPP, Staff Director and Chief Counsel 

JOYCE A. RECHTSCHAFFEN, Minority Staff Director and Counsel 

AMY B. NEWHOUSE, Chief Clerk

FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL 

SECURITY SUBCOMMITTEE 

PETER G. FITZGERALD, Illinois, Chairman 

TED STEVENS, Alaska 

GEORGE V. VOINOVICH, Ohio 

ARLEN SPECTER, Pennsylvania 

ROBERT F. BENNETT, Utah 

JOHN E. SUNUNU, New Hampshire 

RICHARD C. SHELBY, Alabama 

DANIEL K. AKAKA, Hawaii 

CARL LEVIN, Michigan 

THOMAS R. CARPER, Delaware 

MARK DAYTON, Minnesota 

FRANK LAUTENBERG, New Jersey 

MARK PRYOR, Arkansas

MICHAEL J. RUSSELL, Staff Director 

RICHARD J. KESSLER, Minority Staff Director 

TARA E. BAIRD, Chief Clerk 

(III)

C O N T E N T S 

Opening statements: Page 

Senator Fitzgerald ............................................................................................ 1

Senator Collins ................................................................................................. 4

Senator Akaka .................................................................................................. 5

WITNESSES 

MONDAY, NOVEMBER 3, 2003

Stephen M. Cutler, Director, Division of Enforcement, U.S. Securities and 

Exchange Commission ......................................................................................... 7

Paul F. Roye, Director, Division of Investment Management, U.S. Securities 

and Exchange Commission .................................................................................. 11

Hon. William F. Galvin, Secretary of the Commonwealth of Massachusetts ..... 15

Hon. Eliot L. Spitzer, Attorney General for the State of New York .................... 17

Mary L. Schapiro, Vice Chairman and President Regulatory Policy and Oversight, National Association of Securities Dealers .............................................. 20

Hon. Richard H. Baker (R–LA), Chairman, Subcommittee on Capital Markets, 

Insurance and Government Sponsored Enterprises, Committee on Financial 

Services, U.S. House Representatives ................................................................ 33

John C. Bogle, Founder and Former CEO, The Vanguard Group ....................... 38

Mercer E. Bullard, Founder and President, Fund Democracy, Inc. .................... 40

Matthew P. Fink, President, Investment Company Institute .............................. 42

ALPHABETICAL LIST OF WITNESSES

Baker, Hon. Richard H.: 

Testimony .......................................................................................................... 33

Prepared statement .......................................................................................... 120

Bogle, John C.: 

Testimony .......................................................................................................... 38

Prepared statement .......................................................................................... 130

Bullard, Mercer E.: 

Testimony .......................................................................................................... 40

Prepared statement .......................................................................................... 154

Cutler, Stephen M.: 

Testimony .......................................................................................................... 7

Prepared statement .......................................................................................... 59

Fink, Matthew P.: 

Testimony .......................................................................................................... 42

Prepared statement .......................................................................................... 186

Galvin, Hon. William F.: 

Testimony .......................................................................................................... 15

Prepared statement .......................................................................................... 97

Roye, Paul F.: 

Testimony .......................................................................................................... 11

Prepared statement .......................................................................................... 80

Schapiro, Mary L.: 

Testimony .......................................................................................................... 20

Prepared statement .......................................................................................... 111

Spitzer, Hon. Eliot L.: 

Testimony .......................................................................................................... 17

Prepared statement .......................................................................................... 105

Page

IV

APPENDIX

E. Scott Peterson, Global Practice Leader of Defined Contribution Services, 

prepared statement .............................................................................................. 210

Questions and responses for the record from Mr. Roye from Senator Akaka .... 222

(1)

MUTUAL FUNDS: TRADING PRACTICES AND 

ABUSES THAT HARM INVESTORS 

MONDAY, NOVEMBER 3, 2003

U.S. SENATE, SUBCOMMITTEE ON FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY, OF THE COMMITTEE ON GOVERNMENTAL AFFAIRS, Washington, DC. 

The Subcommittee met, pursuant to notice, at 10:32 a.m., in 

room SD–342, Dirksen Senate Office Building, Senator Peter G. 

Fitzgerald (Chairman of the Subcommittee) presiding. 

Present: Senators Fitzgerald, Collins, and Akaka. 

OPENING STATEMENT OF SENATOR FITZGERALD 

Senator FITZGERALD. Good morning. I would like to call the Subcommittee hearing to order. I would like to thank our distinguished 

witnesses for being here today. I would also like to thank the 

Chairman of the full Committee, Senator Collins, for being present, 

as well as our Ranking Member, Senator Akaka. 

Today, we are conducting an oversight hearing on the mutual 

fund and investment advisory industry. We are here to investigate 

the breadth and the extent of the illicit trading practices that have 

come to light in recent months and to examine the impact that the 

abusive practices have had on ordinary mutual fund investors. 

We are also here to reexamine mutual fund management and 

governance and specifically to identify statutory and/or regulatory 

reforms that should be enacted in order to prevent a recurrence of 

the abuses and to better protect fund shareholders. 

Just two decades ago, the mutual fund industry was relatively 

small, but today it is enormous. In 1980, only a small percentage 

of Americans invested in mutual funds, and the assets of the industry only totaled about $115 billion. Today, roughly 95 million 

Americans own shares in mutual funds, and the assets of all of the 

funds combined are now more than $7 trillion. 

Mutual funds have grown in popularity in part because they provide a convenient means of achieving diversification, professional 

management and liquidity, but the Federal Government has also 

given the mutual fund industry an enormous boost. In the past two 

decades, Congress has sanctioned or expanded a variety of tax-sheltered savings vehicles such as 401(k)s, Keoghs, traditional IRAs, 

Roth IRAs, rollover IRAs, and college savings plans. 

One effect of these relatively new investment vehicles is that 

they have turbo-charged the growth of the mutual fund industry 

and given it a guaranteed and, at least to a certain extent, a capVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
2

tive clientele. Millions of Americans now set aside money from 

their twice-monthly paychecks and have it automatically funneled 

into their mutual fund accounts. 

As John Bogle, who will testify later this morning, has observed, 

the coming to light of the market timing and late trading scandals 

is a blessing in disguise. The growth of the mutual fund industry 

has been so rapid during the past 20 years that the industry has 

managed to escape the thorough review and oversight that it merits. The current scandal prods both Congress and regulators to 

catch up with the industry and to reexamine its whole setup. Given 

that mutual funds are now the repository of such a large share of 

so many Americans’ savings, few issues we confront are as important as protecting the money invested in mutual funds. 

Several of the witnesses who are here today will explain the mechanics, the extent, and the scope of market timing, late trading 

and other abusive practices that harm ordinary fund shareholders. 

I am confident that the SEC, State Attorneys General and other 

regulators can curb these abuses in the future, and certainly Congress can pass laws, if necessary, to bolster the authority of the 

SEC in this regard. 

But our current focus on particular types of trading abuses must 

not prevent us from seeing the big picture. It is time for a wholesale reexamination of how mutual funds are organized and managed. As several of our witnesses will testify today, the governance 

structure of a typical mutual fund is a study in institutionalized 

conflict of interest. Until we eliminate the conflicts, many mutual 

funds will continue to engage in behavior that benefits fund managers at the expense of fund shareholders. 

Mutual funds typically have a board of directors, but no staff. 

The board outsources all investment functions to an outside investment advisory firm which charges the fund management and other 

fees. Almost always many of the directors of the mutual fund, including the chairmen, are also insiders of the investment advisory 

firm. Surprisingly, Federal law not only allows this incestuous relationship, it codifies it. The law apparently places faith in the false 

concept that fund directors can bargain at arm’s length with themselves. Because of the incestuous relationship between mutual fund 

directors and their investment advisers, investment management 

and other fees charged to most mutual funds are far too high. 

As Attorney General Spitzer will testify, in 2002, mutual funds 

paid advisory fees of more than $50 billion and other management 

fees of nearly $20 billion, not to mention tens of billions that the 

funds spend on trading costs. 

Also, as Attorney General Spitzer points out in his testimony, in 

most industries, there are economies of scale. One would think that 

as mutual fund assets increased, advisory fees decrease, but, in 

fact, it appears that the reverse is true. It appears that as mutual 

fund assets have risen, advisory fees have risen even more. Mr. 

Spitzer, citing Mr. Bogle, will argue that between 1980 and 2000, 

mutual fund assets grew by 60 times, but the funds, fees and expenses grew by 90 times. 

America’s mutual fund industry has enabled millions of Americans, who otherwise would have been unable, to invest in debt and 

equity securities. It has contributed substantially to keeping our 

3

country’s capital formation system the best in the world, but its institutionalized conflicts of interest have cost Americans dearly. The 

recent industry scandals merely highlight that in trying to serve 

two masters, many fund directors have all too often preferred the 

investment advisory firms with which they are associated over the 

mutual fund shareholders whom they should theoretically be trying 

to protect. 

Late trading and market timing abuses cost fund investors a 

bundle, but management fees, distribution fees, sales charge on 

purchases, so-called loads, purchase fees, deferred sales charges, 

so-called deferred loads, account fees and other charges cost investors many times more. Even small differences in these fees can 

translate into the large differences in returns over time. 

The combination of excessive and opaque fees, abusive trading 

practices, coupled with government policies which channel investors, automatically, into mutual funds has transformed this once 

sleepy industry into a monster. 

The mutual fund industry is now the world’s largest skimming operation—a $7-trillion trough from which fund managers, brokers 

and other insiders are steadily siphoning off an excessive slice of 

the Nation’s household, college and retirement savings. We may 

only be talking about a skim of a few basis points here and a few 

basis points there, but when the skim is multiplied by $7 trillion, 

and then compounded over 10, 20, 30 or more years, pretty soon 

we are talking about real money. But because no one has to write 

a check for these fees and costs and because it makes so much 

sense to have a tax-sheltered retirement or college savings account, 

relatively few have questioned the industry’s practices or fees, let 

alone its bizarre governance structure. And, unfortunately, too few 

have listened to industry reformers like John Bogle, who has been 

sounding the alarm for years, until now, that is, John. 

The current scandal gives us the opportunity to rethink the 

whole mutual fund industry. In my judgment, in addition to the obvious tightening to prevent market timing and late trading we 

must do at least the following: 

No. 1, require that at least 75 percent of the fund’s directors, including and especially the chairman, be independent, and tighten 

the definition of independent directors; 

No. 2, clarify the fiduciary duty a fund director owes to fund 

shareholders and make that duty preempt any possible conflicting 

duties that a director may owe to any vendor to the fund; 

No. 3, require mutual funds to competitively bid out all investment advisory contracts and perhaps other contracts; 

No. 4, substantially tighten the fee disclosure requirements for 

mutual funds; 

No. 5, require brokers who steer customers into a particular fund 

to disclose in writing to the customer the compensation that the 

broker will receive due to the transaction. I am referring to socalled 12b–1 fees. In Chicago, they call those kickbacks. [Laughter.] 

No. 6, finally, we ought to consider facilitating the creation of 

more mutual funds that are truly mutual, ones where like Vanguard, the funds actually own the firm. 

Before I introduce our witnesses, I would like to ask Senator Collins and Senator Akaka if they have opening statements. 

4

We will allow the Chairman to go first, the Chairman of the full 

Committee. 

Chairman COLLINS. Thank you. We are both being so polite here. 

Senator FITZGERALD. That is right. Thank you. Senator Collins. 

OPENING STATEMENT OF CHAIRMAN COLLINS 

Chairman COLLINS. Thank you, Mr. Chairman. 

Let me begin by saluting you for your leadership and your hard 

work in investigating this issue and convening this very important 

hearing this morning. This hearing is about abusive and, in some 

cases, possibly illegal practices allowed by some mutual fund companies, but the hearing is about more than that. It is really about 

people, good, hardworking, middle-income families who are doing 

their best to plan for their retirement or to save for their children’s 

education by investing their savings in mutual funds that have 

long been promoted as a haven for small investors. 

Of all of the components in the financial industry, the mutual 

fund sector has perhaps the greatest responsibility to safeguard the 

interests of small investors. Yet, within the last 2 months, more 

than a dozen companies have been named in allegations of misusing millions of dollars of their investors’ money. These practices 

benefit a select few at the expense of the vast majority of mutual 

fund investors. 

As one of our witnesses has indicated, there is evidence, troubling evidence, that officials at fund companies profited personally 

at the expense of their customers by market timing their own 

funds. 

It is equally troubling to me that this is not a new problem. According to the securities administrator in the State of Maine, similar allegations involving these practices arose in the late 1990’s, 

and yet little has been done since then to protect the Nation’s 95 

million mutual fund investors, 445,000 of whom live in Maine. 

Surely, they deserve better. 

I question why the Securities and Exchange Commission, which 

has regulatory responsibility for the mutual funds and their 

broker-dealers, has failed to detect these practices, to oppose appropriate restrictions or to penalize those who appear to be misusing 

their investors’ money. I question why mutual fund companies and 

their boards of directors would sacrifice the trust of their investors 

in the $7-trillion industry to benefit a select group of individuals 

who can afford to play the mutual fund market. 

Clearly, much more must be done to protect mutual fund investors, whether it is through legislation, tougher enforcement actions, 

new and stronger regulations or all three. We have a regulatory 

system that is supposed to ensure that companies are acting in an 

ethical and legal manner. Mutual fund companies have boards of 

directors who are supposed to fulfill their fiduciary obligations toward their investors, and yet these abuses occur over and over 

again. The system is obviously flawed. 

As the Chairman may well remember, I spent 5 years in the 

State of Maine as commissioner of the department with responsibility for securities regulation. This is an issue that is of great interest to me. We need to know what actions will be most effective 

5

in stopping these abusive practices once and for all, and this hearing is certainly a worthwhile step in that direction. 

Thank you, Mr. Chairman. 

Senator FITZGERALD. Thank you, Madam Chairman. May I just 

ask you what office had that responsibility for securities in Maine? 

Chairman COLLINS. I was the Commissioner of the Department 

of Professional and Financial Regulation, and that includes the Securities Division. Our administrator in Maine was the recent chair 

of the National Association of Securities Administrators and 

worked very closely with some of our witnesses today. 

Senator FITZGERALD. Well, thank you. Senator Akaka. 

OPENING STATEMENT OF SENATOR AKAKA 

Senator AKAKA. Thank you very much, Mr. Chairman. I want to 

thank you very much and to tell you that I appreciate your conducting this hearing today. 

I also would like to thank Representative Baker for his leadership on the important issue of mutual fund governance. 

As the Chairman of the full Committee on Governmental Affairs 

mentioned, this hearing is about the hard-working people of our 

country who have placed their—and I want to emphasize this 

word,—‘‘Trust’’ in the hands of experts to ensure productive investments for a better future are being properly managed. Because of 

this, we are taking steps in the direction of improving what many 

in the mutual fund industry are doing and to, in some cases, because of the letters I have received, restore their trust. 

Trust, as we know, is the cornerstone of effectively functioning 

markets. The abuses involving mutual funds that have been revised include having different sets of rules for large and small investors, ethical misconduct, and individuals enriching themselves 

illegally at the expense of fund shareholders. I look forward to the 

examination of these abuses by this Subcommittee. 

These revelations are particularly troubling because, as the 

Chairman mentioned, 95 million individuals have placed a significant portion of their future financial security into mutual funds. 

Mutual funds provide working-class Americans with an investment 

vehicle that offers diversification and professional money management. 

Mutual funds are an investment vehicle that the average investors rely on for retirement, savings for their children’s college education and other financial goals and dreams. 

Today’s hearing provides us, and this is important, the opportunity to better understand the troubling issues involving mutual 

funds, such as market timing and late trading which have demonstrated a betrayal of the trust of investors by certain investment 

companies. 

I will be introducing legislation designed to restore public trust 

in mutual funds. I look forward to working with my colleagues, 

Chairman of the Full Committee Collins, Chairman of this Subcommittee Fitzgerald, and Representative Baker to address the 

issues of mutual fund corporate governance. The transgressions 

that have been brought to light make it clear that the boards of 

mutual fund companies are not providing sufficient oversight. To 

be more effective, the boards must be strengthened and made to be 

6

more independent. Investment company boards should be required 

to have an independent chairman, and independent directors must 

have a dominant presence on the board. 

In addition, shelf-space payments and revenue sharing agreements between mutual fund companies and brokers present conflicts of interest that must be addressed. Brokers must be required 

to disclose in writing, to those who purchase mutual company 

shares, the amount of compensation the broker will receive due to 

the transaction, instead of simply providing a prospectus. 

In order to increase the transparency of the actual costs of the 

fund, brokerage commissions must be counted on as an expense in 

filings with the SEC and included in the calculation of the expense 

ratio, so that investors can have a more realistic view of the expenses of their fund. 

My legislation will address the need for increased transparency 

of these financial relationships and transactions in order to ensure 

that individual investors are able to make fully informed decisions 

when purchasing mutual fund shares. 

I want to thank our witnesses for being with us today. I look forward to working with all of you to restore the shattered trust of 

investors and bring about significant reform of the mutual fund industry. 

Thank you very much, Mr. Chairman. 

Senator FITZGERALD. Senator Akaka, thank you very much, and 

I would like to second Senator Akaka’s commendation of Congressman Baker. Congressman Baker is scheduled to be our first witness today, but I am advised that he is now en route to Washington, so we are going to accommodate him on a subsequent 

panel. He is another one who has been like John the Baptist, a 

voice crying in the wilderness, and talking about this issue for a 

long time. Before the current trading abuses came to light, he introduced a very good bill over in the House that would bring much 

needed reforms to the mutual fund industry. 

We will move now to this panel. Our first witness is Stephen M. 

Cutler, who is the Director of the Division of Enforcement at the 

U.S. Securities and Exchange Commission. His division investigates possible violations of securities laws, recommends Commission action, and negotiates proposed settlements on behalf of the 

Commission. Mr. Cutler joined the SEC in 1999 as Deputy Director 

of Enforcement. 

Also joining us from the SEC today is Paul F. Roye, who is the 

Director of the Division of Investment Management. Mr. Roye oversees the $20-trillion investment management industry and administers the securities laws affecting investment companies, including 

mutual funds and investment advisers. I would note that Mr. Roye 

has the same combination of college and law school that I have. He 

is an alumnus of Dartmouth College and the University of Michigan Law School. 

Our third witness is the Hon. William F. Galvin, Secretary of the 

Commonwealth of Massachusetts. As the State’s chief securities 

regulator, Secretary Galvin has earned a national reputation aggressively protecting investors against fraud and has recovered millions of dollars for victims of securities fraud. 

7

1The prepared statement of Mr. Cutler appears in the Appendix on page 59. 

Our fourth witness is the Hon. Eliot L. Spitzer, Attorney General 

for the State of New York. Mr. Spitzer’s inquiry into the trading 

activities of Canary Capital Partners was the first of many subsequent announcements and actions against players in the mutual 

fund industry. Additionally, his investigations of conflicts of interest on Wall Street have been a major catalyst for reform in the Nation’s financial services industry. Prior to being elected Attorney 

General, Mr. Spitzer served as an Assistant District Attorney in 

Manhattan from 1986 to 1992. 

Our fifth witness is Mary L. Schapiro. Ms. Schapiro is Vice 

Chairman and President of Regulation Policy and Oversight at the 

National Association of Securities Dealers. Prior to assuming her 

current duties at NASD, Ms. Schapiro was appointed the Chairman 

of the Commodity Futures Trading Commission in 1994 by President Clinton. Prior to that, she was an SEC Commissioner from 

1988 to 1993, when she was appointed Acting Chairman of the 

SEC. 

I would like to thank all of you for your appearances today, and 

in the interest of the time, your full statements will be included in 

the Subcommittee’s record and we ask that you try to limit your 

summary remarks to about 5 minutes so that we can leave plenty 

of time for questions. 

Thank you. Mr. Cutler, you may proceed. 

TESTIMONY OF STEPHEN M. CUTLER,1 DIRECTOR, DIVISION 

OF ENFORCEMENT, U.S. SECURITIES AND EXCHANGE COMMISSION 

Mr. CUTLER. Thank you, Chairman Fitzgerald, Ranking Member 

Akaka, and Senator Collins and other distinguished Members of 

the Subcommittee. Good morning. Thank you, Mr. Chairman, for 

inviting me to testify today on behalf of the SEC concerning abuses 

relating to the sale and operation of mutual funds. 

As each Member of this Subcommittee has mentioned, more than 

95 million Americans are invested in mutual funds today. For that 

reason, the unholy trinity of illegal late trading, abusive market 

timing and related self-dealing practices that have recently come to 

light are matters that affect us all, and they go right to the heart 

of the trust, the covenant, if you will, between mutual fund and 

other securities professionals and the individual investor. 

As my colleagues and I have gathered evidence of one betrayal 

after another, the feeling I am left with is one of outrage, and I 

feel that not just as a prosecutor, but as a citizen and as a member 

of the investing public. It is intolerable when investment professionals, who are duty-bound to serve their customers’ interests, instead serve their own. The conduct we have seen is antithetical to 

the duties that mutual funds, investment advisers, brokerage firms 

and their employees owe to fund shareholders. Individual investors 

have a right to expect fair treatment and, quite simply, they have 

not gotten it. 

Along with the other regulators sitting at this table, the SEC is 

fully committed to ensuring that those responsible for betraying 

the trust of mutual fund shareholders are held accountable and 

8

brought to justice. Indeed, that process has begun, starting, of 

course, with Mr. Spitzer’s action against the Canary Partners 

hedge fund firm and its principal, Edward Stern. Since then, the 

Commission has brought five enforcement actions involving fraud 

against mutual fund investors. In each one, the Commission staff 

has worked in close coordination with State regulators, including 

my distinguished co-panelists, Mr. Spitzer and Mr. Galvin. I will 

touch on each of the cases very briefly. 

On September 16, the Commission filed a civil action against 

Theodore Sihpol, Canary’s primary contact at Bank of America Securities. We allege that Mr. Sihpol played a key role in enabling 

certain hedge funds to engage in late trading. That is putting orders in after 4 p.m., but receiving the old 4 p.m. price. On the same 

day the Commission commenced its action, the New York Attorney 

General filed a two-count criminal complaint charging Sihpol with 

larceny and securities fraud. 

Less than 3 weeks later, the Commission and the New York Attorney General again announced parallel criminal and civil actions—this time against Steven Markovitz, formerly an executive 

and senior trader with a prominent hedge fund, Millennium Partners. According to the criminal charges and the SEC findings, 

Markovitz engaged in late trading on behalf of his firm. In an impartial settlement of the SEC’s action, Markovitz agreed to be permanently barred from associating with an investment adviser or a 

registered investment company. 

In the first action against a mutual fund executive for permitting 

abuse of market timing, on October 16, the Commission and the 

New York Attorney General announced the arrest, conviction and 

lifetime industry bar of James P. Connelly, Jr., former Vice Chairman of Fred Alger & Company. Market timing, of course, refers to 

the practice of excessive short-term buying and selling of mutual 

fund shares in order to exploit inefficiencies in mutual fund pricing. In its administrative order, the SEC found that Connelly had 

approved agreements that, contrary to Alger’s prospectus disclosure, permitted select investors to market time certain mutual 

funds, in some cases, in exchange for the timers leaving at least 

20 percent of their assets at Alger in buy-and-hold positions. 

The Commission’s order bars Connelly from the industry and imposes a $400,000 civil penalty. 

Most recently, on October 28, in conjunction with the Secretary 

of Massachusetts, the Commission brought enforcement actions 

against Putnam Investment Management and two former Putnam 

portfolio managers, Justin M. Scott, and Omid Kamshad, in connection with Scott and Kamshad’s personal trading in Putnam mutual funds. 

We allege that Scott and Kamshad market timed the very Putnam funds they managed and that Putnam failed to take adequate 

steps to prevent or disclose their self-dealing activity or that of 

other Putnam personnel who engaged in excessive short-term trading of Putnam funds. 

I think I can safely predict that many more enforcement actions 

will follow. We are currently conducting a broad-based inquiry of 

late trading, market timing and related self-dealing practices. On 

September 4, the Commission staff sent detailed compulsory inforVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
9

mation requests to 88 of the largest mutual fund complexes in the 

country and 34 brokerage firms, including all of the country’s registered prime brokers. And just last week, we sent similar requests 

to insurance companies that sell mutual funds in the form of variable annuities. 

Based on the responses to these requests, Commission staff have 

been dispatched to conduct on-site inspections and interviews and 

further investigation at dozens of firms. Although we are continuing to receive and analyze the responsive information, I would 

like to highlight some of the most troubling items. I must emphasize that these are only preliminary and are the subject of continued, active investigation. 

First, on the subject of late trading, more than 25 percent of responding brokerage firms reported that customers had received 4 

p.m. prices for orders placed or confirmed after 4 p.m. E-mails submitted by approximately 10 percent of the responding mutual funds 

contained references to situations that possibly involve late trading. Three fund groups reported—or the information they provided 

indicated—that their staffs had approved a late trading arrangement with an investor. 

Second, on the matter of market timing, we have already reported that 50 percent of responding fund groups appear to have 

had at least one arrangement allowing for market timing by an investor, but in addition to that, documents provided by almost 30 

percent of responding brokerage firms indicate that they may have 

assisted market timers in some way, such as by breaking up large 

orders or setting up special accounts to conceal their own or their 

clients’ identities, a practice sometimes called cloning, to avoid detection by mutual funds that sought to prevent abusive market 

timing. Further, almost 70 percent of responding brokerage firms 

reported being aware of timing activities by their customers. 

Finally, let me mention another potentially abusive practice that 

has gotten attention as well—the selective sharing of mutual fund 

portfolio information. More than 30 percent of responding fund 

companies appear to have disclosed portfolio information in circumstances that may have provided certain fund shareholders the 

ability to make advantageous decisions to place orders for fund 

shares. 

The Commission staff is following up on all of these situations 

closely, along with my colleagues at the table. Let me also point out 

that we are actively engaged in enforcement and examination activities in four other important areas involving mutual funds, some 

of which I know that Mary Schapiro will address. 

The first area is mutual fund sales practices and fee disclosures. 

In particular, we are looking at just what prospective mutual fund 

investors are being told about revenue-sharing arrangements and 

other incentives doled out by mutual fund management companies 

and mutual funds themselves to brokerage firms who agree to feature their funds. 

We are looking at whether there is adequate disclosure of the 

source and the nature of those payments and the fact that they 

may increase costs to investors, as well as create conflicts of interest between investors and the financial professionals with whom 

they deal. 

10

In one case involving a major financial institution, we have already issued a Wells Notice of the staff’s intention to recommend 

what I think would be first-of-their-kind charges by the Commission. 

Our second area of focus is the sale of different classes of shares 

in the same mutual fund. Very frequently, a fund will have issued 

two or more classes of shares commonly referred to as A shares, 

B shares, and so on. Each class will have a different fee structure 

associated with it. In the last 6 months, we have brought enforcement actions against two brokerage firms—Prudential Securities 

and IFG Network Associates—in connection with the alleged recommendations that customers purchased one class of shares when 

the firms should have been recommending another. 

The third area is the abuse of so-called break points. That is a 

fancy term for what are, in essence, volume discounts available to 

investors who make large purchases of mutual fund shares. Quite 

simply, we found numerous instances in which it appears that brokerage firms did not give investors the discounts to which they 

were entitled. This week, together with the NASD, we will be 

issuing Wells Notices to a significant number of brokerage firms for 

their failure in this regard. 

The final area is the pricing of mutual funds beyond the context 

of market timing. We are actively looking at two situations in 

which funds dramatically wrote down their net asset values in a 

manner that raises serious questions about the funds’ pricing 

methodologies. 

Before I conclude, I would like to take a moment to address press 

reports that several months ago an employee in Putnam’s Call Operator Unit told our Boston Office that individual union members 

were day trading Putnam funds in their 401(k) plan. Do I wish 

that we would have brought the Putnam case 2 months ago, instead of 2 weeks ago? Of course, I do. The SEC receives on the 

order of 1,000 communications from the public in the form of complaints, tips, E-mails, letters, and questions every working day. 

That is more than 200,000 a year. 

We have made, and are continuing to make, changes in how we 

handle these, including giving more expeditious treatment to those 

that raise enforcement issues and instituting a monthly review of 

the disposition of each enforcement-related matter by the Division’s 

senior management. Tips from whistleblowers are critical to our 

program. In fact, the investigation of personal trading at Putnam, 

which is what we ultimately sued Putnam for, was launched when 

we received a tip in that area just a few weeks ago. 

Speaking more generally, I am proud of the Commission’s record 

in the enforcement area. In our just-concluded fiscal year, the Commission brought 679 enforcement cases involving just about every 

conceivable type of securities violation. That is a 40 percent jump 

from just 2 years ago. We accomplished this dramatic increase with 

almost no increase in resources, and included in our most recent 

year’s totals are some extraordinary efforts on behalf of the investing public: 

One-and-a-half billion dollars in disgorgement and penalties designated for return to investors using Sarbanes-Oxley fair funds, a 

total of 60 enforcement actions against public company CEOs; 

11

1The prepared statement of Mr. Roye appears in the Appendix on page 80. 

Nearly 40 emergency asset freezes and TROs to protect investors’ 

money on a real-time basis, groundbreaking and important cases 

against brokerage firms and banks for their roles in the Enron debacle; 

The first-ever case against a mutual fund management company 

for failure to disclose a conflict of interest in the voting of its fund’s 

proxies; 

A first of its kind case against a major insurance company for 

aiding and abetting an issuer’s financial statement fraud; 

Multiple cases alleging violations of the Commission’s new selective disclosure rule; 

And dozens of financial fraud cases against Fortune 500 companies and their auditors. 

The dedication, commitment, and professionalism of our enforcement staff are second to none. With Congress’s help, we have now 

begun to see additional resources. With more people and better 

technology, our mandate from Chairman Donaldson is to more 

proactively identify problems and to look around the corner for the 

next fraud or abuse. 

With respect to mutual funds, I know that the Agency’s routine 

inspection and examination efforts will be improved by adding new 

staff, increasing the frequency of examinations, and digging deeper 

into fund operations. We are working aggressively on behalf of 

America’s investors to ferret out and punish wrongdoers wherever 

they may appear in our securities markets, including the mutual 

fund area. And at the same time that the Commission is looking 

backwards to identify and punish past misconduct, the Commission 

has been engaged in a comprehensive regulatory response designed 

to prevent problems of this kind from occurring in the first place. 

My colleague, Paul Roye, Director of the Division of Investment 

Management, will discuss those initiatives. 

Thank you, and I would be happy to answer any questions that 

the Subcommittee has. 

Senator FITZGERALD. Thank you, Mr. Cutler. Mr. Roye. 

TESTIMONY OF PAUL F. ROYE,1 DIRECTOR, DIVISION OF INVESTMENT MANAGEMENT, U.S. SECURITIES AND EXCHANGE 

COMMISSION 

Mr. ROYE. Thank you, Chairman Fitzgerald, Ranking Member 

Akaka, and Senator Collins, and distinguished Members of the 

Subcommittee. 

Like Steve, on behalf of the Securities and Exchange Commission, I appreciate the opportunity to discuss possible regulatory responses to recent allegations of abusive practices in the mutual 

fund industry, and initiatives to improve the regulatory framework 

governing mutual funds. 

As has been noted, with over 95 million Americans invested in 

mutual funds, representing approximately 54 million U.S. households and a combined $7 trillion in assets, mutual funds are unquestionably one of the most important elements of our financial 

system. 

12

The conduct alleged in the various cases brought by the Commission, as well as the New York Attorney General and the Secretary 

of the Commonwealth of Massachusetts represent reprehensible 

conduct that are gross violations of the Federal securities laws, as 

well as basic fiduciary principles. 

As my colleague Steve Cutler just outlined for you, the Commission has put in motion an action plan to vigorously investigate 

these matters, assess the scope of the problem and hold wrongdoers 

accountable. Now, while our enforcement efforts are a key tool in 

protecting the Nation’s investors, another critical component is the 

regulatory framework designed to prevent or minimize these 

abuses from happening in the future or happening in the first 

place. 

Before I discuss regulatory initiatives in this area, I would like 

to take a moment to place these initiatives in context. In recent 

years, the Commission has had a principle focus on strengthening 

the mutual fund governance framework. The Commission has 

adopted rules that effectively require fund boards to have a majority of independent directors, and require that independent directors 

select and nominate other independent directors to fill vacancies on 

fund boards. 

We promoted the concept of independent legal counsel for fund 

directors, enhanced disclosures regarding directors, including information concerning whether the directors own shares of the funds 

that they oversee, and information about independent director potential conflicts of interest; as well as disclosures about the board’s 

role in how they govern the funds, including the basis upon which 

they renew a fund’s investment advisory contract. 

More recently, the Commission has tailored the provisions of the 

Sarbanes-Oxley legislation to apply to mutual funds, including the 

provisions to improve oversight and internal controls, such as key 

officer certifications and code of ethics requirements. The Commission has proposed that each fund have a chief compliance officer reporting to, and accountable to, fund independent directors whose 

responsibility it would be to provide that the fund has procedures 

in place reasonably designed to ensure compliance with the Federal 

securities laws. 

And the Commission also has supported key provisions of the 

legislation that has been referenced that was introduced by Congressman Richard Baker, to further enhance mutual fund governance, including provisions that give the Commission the authority 

to close gaps in the definition of independent director in the Investment Company Act of 1940. 

Indeed, so far this year the Commission has proposed or adopted 

16 different rulemakings related to mutual funds. Again, through 

these rulemakings, the Commission has sought to enhance fund 

governance and internal controls, improve fund disclosures, and 

minimize conflicts between funds and their managers. 

We sought public input on additional measures that the Commission should take to improve the mutual fund regulatory framework 

so that we can avoid these problems that we are currently investigating. 

In addition, our staff in September issued a comprehensive report on hedge funds, making a series of recommendations to imVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
13

prove the Commission’s ability to monitor the activities of these vehicles, the most significant being a recommendation to require that 

hedge fund advisers register under the Investment Advisers Act of 

1940, and therefore become subject to Commission examination 

and routine oversight. 

Now, this review of hedge funds and the staff’s recommendations 

become all the more important when we consider that we have 

seen a number of hedge funds engaging in late trading and market 

timing activity of mutual fund shares, indeed, serving as the impetus for the current investigations and enforcement actions related 

to these activities. 

Now, the 16 rulemakings that we have done so far in 2003, along 

with those to come, combined with the staff’s work on hedge funds, 

will represent, to my knowledge, the Commission’s most productive 

year in investment management regulation since the Commission 

was charged in 1940 with overseeing this segment of the financial 

services industry, and I think fund investors are benefiting from 

these proactive initiatives, but we are not done yet. 

You can expect significant mutual fund regulatory initiatives before this year is through. On October 9, slightly more than a month 

after the New York Attorney General announced his actions 

against Canary Partners, Chairman Donaldson outlined a regulatory agenda to confront and address late trading and market timing abuses to help restore confidence in the fairness of the mutual 

fund operations and practices. 

He requested our staff to submit rulemaking recommendations to 

the Commission this month to address these issues, and we are 

going to meet that demand. 

In preparing its recommendations to the Commission, the staff is 

examining requiring that the fund or its designated agent, rather 

than intermediaries such as broker-dealers or parties that we do 

not regulate, receive a purchase or redemption order for fund 

shares by 4 o’clock for an investor to receive that day’s price. 

Now, this hard 4 o’clock cut-off we believe would effectively eliminate the potential for late trading through intermediaries that sell 

fund shares. Staff is also considering recommending that the Commission address late trading in connection with the recommendation to adopt the mutual fund compliance policies rule which the 

Commission proposed in February of this year. Again, this proposal 

calls for a chief compliance officer who is accountable to the fund 

directors, whose responsibility it would be to ensure that funds 

have effective policies and procedures in place to prevent such activity as late trading. 

With respect to market timing, we are preparing recommendations to require explicit disclosure and fund offering documents of 

market timing policies and procedures. And this disclosure would 

enable investors to assess a fund’s market timing practices and determine if those practices are in line with their expectations. 

The rule recommendations requested by the Chairman would 

have a further component of requiring funds to have procedures to 

comply with these representations regarding market timing policies. Thus, if a fund’s disclosure documents stated that it took action or will take action to discourage market timing, the fund will 

14

be required to have procedures in place to assure that it is complying with these representations to investors. 

The establishment of formal procedures would enable our examination staff to review whether or not these procedures are being 

followed and whether or not the fund is living up to its representations regarding curbing market timing activity. 

The Commission also will emphasize the obligations of funds to 

fair value price their securities so as to avoid stale pricing, to minimize market timing arbitrage opportunities. We think this is an 

important measure to combat market timing activity. 

Steve mentioned allegations of portfolio managers market timing 

the funds they manage or other funds in the complex, This raises 

issues regarding insider trading, as well as the need for an adherence by fund personnel to policies and procedures to prevent the 

misuse of material nonpublic information. We expect that this issue 

will also be addressed in the rulemaking recommendations that we 

are going to submit to the Commission later this month. 

Recent allegations indicate that some fund managers may be selectively disclosing their portfolios in order to curry favor with 

large investors. Selective disclosure of a fund’s portfolio can facilitate fraud and have severely adverse ramifications for a fund’s investors if someone uses that portfolio information to trade against 

the fund. So, consequently, the Chairman has asked the staff to 

consider whether additional requirements are necessary to reinforce funds and adviser’s obligations to prevent the selective disclosure of fund portfolio holdings information in a manner that can 

harm investors. 

In addition to these initiatives, we have been asked to consider 

whether funds should have additional tools available to thwart 

market timing activity, such as mandatory redemption fees or allowing funds to retain the profits of short-term traders in their 

shares. If we take away the profit potential that can be gained by 

market timers, we can eliminate abuses in this area. 

Now, Chairman Donaldson has emphasized that he will not hesitate to call for other regulatory measures if we discover additional 

information in the course of our investigation that merits regulatory action, and he has indicated that no reform, whether structural, fund governance or board composition is off the table. The 

Commission is committed to moving swiftly and aggressively to 

take all necessary steps to protect mutual fund investors from abusive and harmful activity. 

In addition to the initiatives to address late trading and market 

timing abuses, the staff and Commission have been working on 

other initiatives designed to assist mutual fund investors in making the best investment decisions for themselves, to attack inappropriate mutual fund sales practices and bolster confidence in the 

mutual fund industry. 

Now, these initiatives seek to provide for complete transparency 

of fees and expenses, improve the fund governance framework, including initiatives relating to fund advertising, fund-of-fund products, breakpoint disclosures regarding sales loads, shareholder report disclosure of operating expenses for investors in dollars and 

cents, more frequent disclosure of fund portfolio information so investors can make better asset allocation decisions, enhanced discloVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
15

1The prepared statement of Mr. Galvin appears in the Appendix on page 97. 

sure of incentives and conflicts that brokers have in offering mutual fund shares to investors, and giving investors greater input 

into director nomination initiatives. 

We are committed to moving forward with our mutual fund agenda in these areas as well. And I should also note that with the additional resources and funding from Congress, we are beefing up 

our oversight of the fund industry with additional staffing that will 

allow for more frequent inspections of funds to monitor for compliance with the Federal securities laws. 

In conclusion, I would like to reiterate that the protection of our 

Nation’s mutual fund investors is of paramount importance to the 

Commission and the staff. I can now assure you and assure the 

American public that the Commission will deal immediately with 

the reprehensible abuses that are taking place. We are committed 

to rooting out the problems, punishing the perpetrators and putting 

the proper rules in place so that these abuses do not happen in the 

future. 

Again, I appreciate the opportunity to be here, and I would be 

happy to answer any questions. 

Senator FITZGERALD. Mr. Roye, thank you very much. 

Secretary Galvin, you may proceed. I would reiterate, we would 

ask that you stick to 5 minutes because we have to leave time both 

for another panel and for questions of both panels. 

Thank you. 

TESTIMONY OF HON. WILLIAM F. GALVIN,1 SECRETARY OF 

THE COMMONWEALTH OF MASSACHUSETTS 

Mr. GALVIN. Thank you, Mr. Chairman. I am Bill Galvin, Secretary of State and Chief Securities Regulator of Massachusetts. I 

want to commend Senator Fitzgerald, Senator Collins, and Senator 

Akaka for calling today’s hearing to examine mutual fund abuses. 

Mutual funds, as has been stated, play a major role in the wealth 

and savings of our Nation. Today, half of all American households 

invested nearly $7 trillion in mutual funds, but mutual funds are 

about more than money under management. Mutual funds are 

about the hopes and dreams of middle-income Americans, the 

hopes of a financially secure and dignified retirement, the dream 

of a college education for a child. Mutual funds are where America’s dreams are invested. 

Investors have placed their trust in mutual funds with the understanding that they would be treated fairly, that the risk of the 

market would be offset by the skill and commitment of fund managers. We are here today because in too many instances the mutual 

fund industry has failed to live up to its duty. The common theme 

running through all of the mutual fund issues that we have exposed in recent months is that the mutual fund industry is putting 

its own interest ahead of their consumers and customers. 

While they market trust and competence, too often they have delivered only deceit and underperformance. We are also here today 

because self-policing and government laws and law enforcement 

have also failed to effectively protect the investor. The evidence 

that self-policing has failed is in the willingness of the entire indusVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
16

try to quietly tolerate known market abuses while they parse 

words trying to describe clearly unethical practices as not illegal. 

Their past silence has convicted them of ineffectiveness. 

Government laws and law enforcement have failed because they 

have failed in the past to aggressively and properly enforce the 

law. For too long, a culture of compromise and accommodation has 

overwhelmed enforcement efforts. Too often the guilty neither 

admit nor deny any wrongdoing and routinely promise not to cheat 

again until they can come up with a more clever way to do what 

they just said they would not do again. 

For too long, while the merry-go-round of accusation and nonadmission goes round and round, investors have been the losers. It 

has taken the coincidence of dramatic and tragic recent investor 

losses and aggressive State enforcement by people like Attorney 

General Spitzer and myself to convert investor outrage to a call for 

action. 

We have uncovered insider trading in Massachusetts at its worst, 

fund managers exploiting their inside knowledge for personal profit 

at the expense of their customers. We have uncovered a pervasive 

pattern of breach of duty and corporate deceit at Putnam Investment, the Nation’s fifth-largest mutual fund company. Simply put, 

investors were cheated. 

In August, my office uncovered a hidden compensation scheme at 

Morgan Stanley, including cash prizes and other lucrative benefits 

designed the push Morgan Stanley mutual funds on unsuspecting 

investors who were seeking honest advice. 

These enforcement actions are only two examples of the deep 

problems in the industry. Mutual funds violate investor trust in a 

number of ways—when mutual funds allow market timing for their 

employees, when mutual funds allow market timing for certain outside investors, perhaps as an incentive to generate or retain business, when mutual funds allow late trading in fund shares, when 

mutual funds pay higher commissions to brokers or other incentives to sell proprietary or in-house funds to investors rather than 

funds that may be more suitable to the investor’s needs and when 

break-point discounts are ignored or concealed. 

State securities regulators are often the first to identify investment-related problems and to bring enforcement actions to halt and 

remedy these problems. Any suggestion that the state regulators 

have hindered Federal enforcement of securities law is completely 

false. Any effort to restrict or preempt State enforcement must be 

called what it clearly is—anti-investor. 

H.R. 2420 is a positive response to some of the many problems 

investors in mutual funds now face, and I endorse its objectives. 

The bill can be improved, however. The original language of Section 1, regarding fund operating expenses, should be restored. Each 

individual investor should be notified of the actual cost they are 

paying, and instead of simply disclosing soft-dollar costs, they 

should be banned. 

Prompt passage of this bill is important to bring the regulation 

of mutual funds to the level of regulation that their role in our financial system demands, but laws alone are not enough. They 

must be vigorously enforced. 

17

1The prepared statement of Mr. Spitzer appears in the Appendix on page 105. 

Again, I want to commend the Subcommittee for focusing attention on this situation. With strengthened laws and vigorous enforcement, we can give our Nation’s investors the fairness and honesty they seek and the protection they deserve. 

Thank you. I will be happy to answer any questions you might 

have. 

Senator FITZGERALD. Secretary Galvin, thank you. Attorney General Spitzer. 

TESTIMONY OF HON. ELIOT L. SPITZER,1 ATTORNEY GENERAL 

FOR THE STATE OF NEW YORK 

Mr. SPITZER. Thank you very much, Mr. Chairman, Senator Collins, and Senator Akaka. Thank you so much for having this hearing today. 

Senator Fitzgerald, I would be tempted to ask that my testimony 

be stricken and your opening statement be substituted for it. It was 

a very powerful statement encapsulation of precisely what is wrong 

with the industry and, indeed, many of the ideas that need prospectively to be adopted to remedy the problems we have been discussing in past months. 

I would also share in your kind words for Mr. Bogle, who for 

many years—decades perhaps—has been, as you said, a voice in 

the wilderness diagnosing these problems, and yet nobody wished 

to hear it. 

It is indeed the case that others have said this occasionally, and 

I would wish to quote Paul Samuelson, who was not only a Nobel 

laureate in economics, but also one who was very wise in his understanding about capital markets. He said, about 35 years ago, ‘‘I 

decided that there was only one place to make money in the mutual fund business, as there is only one place for a temperate man 

to be in a saloon—behind the bar and not in front of the bar. So 

I invested in a mutual fund management company.’’

He understood very well, ultimately, how the incentive structure 

we created would result in money being made by those who managed, not necessarily to the exclusion, but certainly to the hindrance, of those on behalf they were investing. 

One of the pities of what has now become a well-documented 

story and tale of abuse is that the evidence of this abuse is very 

obvious. Those who wish to look should have been able to see it. 

Those in management positions have understood, and if those on 

boards of directors or advisory companies or management companies had gone to even the minimal effort that they are supposed 

to go to, they would have seen these abuses. 

Unfortunately, just as we saw last year in our investigation of 

conflicts of interest at the investment companies with respect to research, internal compliance, internal aggressiveness simply was not 

there. Indeed, most remarkably, the mutual fund companies, over 

the past 3 years, have protested their innocence. They have 

claimed that they are pure, they are clean as the driven snow. For 

many of us, the most remarkable intersection and most remarkable 

evidence of this was about a year ago, when there was a proposal, 

a very wise proposal that I think has been adopted by the SEC that 

18

would have required mutual fund companies to disclose how they 

were voting their proxies. 

The mutual fund company, in what can only be described as an 

act of grotesque arrogance, said, no, we do not want to disclose this 

information. It will be too expensive—too expensive to tell the 

American public how they were voting the proxies of shares that 

were owned in trust for the American public at the very time that 

they were raking off $50 billion in fees, of advisory fees, and $20 

billion in fees above and beyond that. Too expensive they said. 

That, for me, and for many others, I believe, was the opening 

salvo in what, for us, was an effort to unwind what has been clear 

and ongoing abuses by an industry that has, until now, held itself 

to be above the law. 

As you pointed out Senator Fitzgerald, in your opening comments, between 1980 and the present, funds under management 

have grown by 60 times, and yet fees have grown by 90 times. 

Where are the economies of scale that have been promised year 

after year by this industry, economies of scale that have been used, 

they believe, they have argued, to justify not only the 12b–1 fees, 

but every other type of fee that has been piled on top of what they 

have charged the American consumer. 

CEO tradings. CEO trading has been revealed in past months. 

That should have been cleared to internal compliance, but nobody 

asked. 

Redemption rates. There were many multiples of the assets 

under management. Clearly, this is a red flag that should have 

made it very evident to somebody somewhere inside these companies that trading patterns were amiss, and yet again nobody did 

anything. Clearly, there has been a problem here. And just to put 

this into perspective, in terms of an order of magnitude, we believe, 

and we know that there will be a dispute of this figure by the ICI. 

We believe these numbers are correct. We believe that on the order 

of a 25-basis point differential exists between what mutual funds 

are charged for management versus pension funds. 

Twenty-five basis points does not sound like a great deal unless 

you aggregate the numbers. Twenty-five basis points spread across 

the entirety of the funds under management would save the American mutual fund investor $10 billion every year. 

If mutual funds were charging what pension funds were charged 

for what we believe to be comparable services, $10 billion would 

flow back to the American investor. Those numbers swamp the impropriety that we have found in late-day trading and timing, and 

therefore deserve to be the subject of intense focus. Again, to put 

this into perspective for the individual investor, a small investor or 

an individual investor with $100,000 over 10 years would aggregate an incremental $6,000—merely by reducing by 25 basis points 

the fees that are charged by the management companies. 

Why is this relevant? It is relevant because we do not believe the 

management companies have in any way, shape or form negotiated 

aggressively to drive those fees down. 

Now, let me—and I understand that time is of the essence here—

let me very quickly discuss two areas that are important, and this 

is the area, a question of how we handle this prospectively. Prospectively we must address two entirely distinct issues. One is the 

19

regulatory framework for timing and late-day trading. I think it 

should be understood by all investors and this Subcommittee that 

the rules with respect to those issues are basically clear. We do not 

necessarily, although I would encourage the SEC to adopt new 

rules, the problem here has not been an absence of rules, the problem has been a failure of compliance. It is outright illegal conduct 

that was not caught, that should have been caught and that is now 

being caught and will be aggressively prosecuted. 

In order to reach a settlement with my office for violations of either late trading or timing, let me make it very clear what the 

companies that committed improper acts will have to do, and I will 

merely focus on two issues. One, they will have to assure us that 

there is a compliance program that will guarantee that these 

abuses will be caught prospectively; 

In addition to full disgorgement and restitution to shareholders, 

there will need to be a disgorgement of all—and I repeat the word 

‘‘all’’—fees that were earned with respect to any fund during the 

period of time during which there was illegal behavior. There is absolutely no room for the receipt of fees during the period of time 

during which funds are violating a clear fiduciary duty. This number will be big, it will impose pain, and it should. 

Second, there is an entirely distinct area, and this you alluded 

to, Mr. Chairman, the governance of these funds. This is where we 

need to rethink, in its entirety, the framework that has been created legislatively. There is no question at all the boards of directors 

of the mutual funds have been inert, they have been passive, they 

have failed. They have utterly failed the investor. They have misunderstood their role. They have not been responsive to the appropriate parties, and this must change. The ideas that you captured 

in your opening statement, at a minimum, must be embodied in 

law, and I applaud you for suggesting them. 

Let me add one more notion to that litany that you described, 

and that is something called a Most Favored Nation’s clause. This 

is a notion that I think should be forced upon the boards. They 

should require that their fee structures with management and advisory companies include a Most Favored Nation clause that would 

stipulate that if any other entity is receiving a lower price for the 

same service, the entity on whose board they sit must receive that 

lower price. This would cut to the heart of what we believe is an 

impropriety, which permits pension funds and others to pay less 

than mutual funds are paying for comparable services and would 

address that chasm, the $10-billion divide that separates what investors get from what they should get. 

Let me make one very quick final point. Much has been said and 

made recently of the relationship between my office and the SEC. 

There are times when, indeed, I have been critical of the SEC and 

their failure to catch some of these abuses. I do not regret or withdraw my comments or my feeling that we collectively, as prosecutors and regulators, should have done better. However, I wanted to 

be perfectly clear at several levels. 

One, we have, we will continue, and we have absolutely no difficulty corroborating in entirety with the SEC. We will work hand 

in glove with them as we go forward. They are, must be and will 

continue to be the primary regulator of the securities markets. The 

20

1The prepared statement of Ms. Schapiro appears in the Appendix on page 111. 

enforcement bureau, under the leadership of Mr. Cutler, has done 

a yeoman’s work in the past years trying to clean up what has been 

a torrent, a tidal wave of abuses, and I have nothing but respect 

for the job that they have done. And so I hope that those who think 

that there is some divide between us and wish to play upon that 

perception, I hope that they will be corrected in that very important misconception. 

Thank you very much, Mr. Chairman. 

Senator FITZGERALD. Thank you, Mr. Spitzer. Ms. Schapiro. 

TESTIMONY OF MARY L. SCHAPIRO,1 VICE CHAIRMAN AND 

PRESIDENT OF REGULATORY POLICY AND OVERSIGHT, NATIONAL ASSOCIATION OF SECURITIES DEALERS 

Ms. SCHAPIRO. Thank you very much. Good morning, Mr. Chairman, Senator Akaka and Senator Collins. I appreciate having the 

opportunity to testify on behalf of NASD. 

NASD is the world’s largest securities self-regulatory organization. We have a nationwide staff of more than 2,000 who are responsible for writing rules that govern securities firms, examining 

those firms for compliance and disciplining those who fail to comply. Last year, NASD filed more than 1,200 new enforcement actions, levied record fines and barred or suspended more individuals 

from the securities industry than ever before. 

The reprehensible conduct that has brought us all here today, 

which cheats the public and degrades the integrity of American 

markets, will not be tolerated. Any broker or firm that misleads a 

customer or games the system can expect to be the subject of aggressive enforcement action. 

Due to their enormous growth and popularity in recent years, 

NASD has paid particular attention to how brokers sell mutual 

funds. While NASD does not have jurisdiction or authority over 

mutual funds or their advisers, we do regulate the sales practices 

of broker-dealers who provide one distribution mechanism for mutual funds. 

Our regulatory and enforcement focus has been on the suitability 

of the mutual fund classes that brokers recommend, the sales practices used, the disclosures given to investors, compensation arrangements between the funds and brokers and whether customers 

receive appropriate breakpoint discounts. We have brought some 60 

enforcement cases this year in the mutual fund area and more 

than 200 over the last 3 years. 

Throughout routine examinations, we have found that in 1 out 

of 5 transactions in which investors were entitled to a breakpoint 

discount, that discount was not delivered. Thus, many brokers imposed the wrong sales load on thousands of mutual fund investors—in effect, overcharging investors, by our conservative estimate, $86 million in the last 2 years. 

NASD has directed firms to make immediate refunds, and in the 

next several weeks, with the SEC, we will announce a number of 

enforcement actions seeking significant penalties. 

Brokers are also prohibited from holding sales contests that give 

greater weight to their own mutual funds over other funds. These 

21

types of contests increase the potential for brokers to steer customers towards investments that are financially rewarding for the 

broker, but may not be the best fit for the investor. 

In September, we brought a case against Morgan Stanley for 

using sales contests to motivate its brokers to sell Morgan Stanley’s 

own funds. The sales contests rewarded brokers with prizes, such 

as tickets to Britney Spears and Rolling Stones concerts. This case 

resulted in one of the largest fines ever imposed in a mutual fund 

sales case. 

We have also recently proposed a rule requiring disclosure of two 

types of cash compensation—payments for shelf space by mutual 

fund advisers to brokerage firms that sell their funds and differential compensation paid by a brokerage firm to its salesmen to sell 

the firm’s proprietary funds. Customers have a right to know that 

these compensation deals which create serious potential for conflict 

of interest exist, whether the compensation is paid in cash or in the 

form of basketball tickets. 

Over the last 2 years, NASD has brought more than a dozen 

major cases against brokers who have recommended that investors 

buy Class B shares of mutual funds in which the investors incur 

higher costs and brokers receive higher compensation. We have 

more than 50 additional investigations of inappropriate B class 

sales in the pipeline. 

This kind of enforcement effort is continuing with great vigor at 

NASD. We are now looking at more than a dozen firms for their 

practices of accepting brokerage commissions in exchange for placing particular mutual funds on a preferred or recommended list. In 

this effort, we are investigating all types of firms, including discount and on-line broker-dealers and fund distributors. 

A more recent focus of ours has been an investigation into late 

trading and market timing. In September, we sought information 

regarding these practices from 160 firms. Our review indicates that 

a number clearly received and entered late trades. Other firms 

were not always able to tell with clarity whether or not they had 

entered trades late. This imprecision indicates poor internal controls and recordkeeping, issues we will also pursue. 

As we continue our examinations and investigations into these 

matters, we will enforce NASD rules with a full range of disciplinary options, including fines, restitution to customers, and the potential for expulsion from the industry. 

Mutual funds have also been a focus of NASD’s investor education efforts. This year alone we have issued investor alerts on 

share classes, principal protected funds, breakpoint discounts, and 

we unveiled an innovative mutual fund expense analyzer on our 

website that allows investors to compare expenses and fees for 

funds and fund classes and highlighting when they should look for 

breakpoint discounts. 

All of these issues, breakpoints, after-hours trading, market timing, and compensation agreements, are important to NASD because 

they are important to investors. We are committed to building the 

integrity of our financial markets and view our mission in the area 

of broker sales of mutual funds as an important component of that 

overall goal. 

22

In closing, I also want to commend Congressman Baker for his 

work. NASD supports H.R. 2420 and applauds his efforts to bring 

increased transparency to the mutual fund industry. 

I thank you, Chairman Fitzgerald, for your leadership in investigating this area, and we appreciate again the opportunity to testify. I would be happy to answer questions. 

Senator FITZGERALD. Thank you very much. 

We will begin the questioning now, and I would like to start with 

Mr. Cutler. 

I just want to get this straight. In your opening statement, where 

you describe the results of the surveys you have sent out to brokers, did you send surveys to 34 brokers and brokerage firms? 

Mr. CUTLER. That is right. Actually, they are compulsory because, given our inspection power, the brokerage firms must provide us with the relevant information, but, yes, you have it. 

Senator FITZGERALD. And you sent the survey to 88 mutual 

funds? 

Mr. CUTLER. Mutual fund complexes, that is correct. 

Senator FITZGERALD. Complexes. 

Mr. CUTLER. Yes. 

Senator FITZGERALD. Now, you found that 25 percent of the brokers are allowing late trading; is that correct? 

Mr. CUTLER. Well, first, let me again emphasize that these are 

preliminary findings and further follow-up is certainly going to 

happen, but, indeed, more than a quarter of the responding brokerage firms reported that they are aware that customers have received 4 p.m. prices for orders placed after or confirmed after 4 

p.m. 

Senator FITZGERALD. And late trading is a violation of the law. 

Mr. CUTLER. Yes, it is, Senator. 

Senator FITZGERALD. And you also reported that more than 30 

percent of the mutual funds have selectively disclosed nonpublic 

fund information to certain customers; is that correct? 

Mr. CUTLER. Well, at this point, I would not say that it is to customers, but, yes, we have concerns that at least in 30 percent of 

the responding fund companies, that there was some disclosure of 

portfolio information under circumstances that at least raise a 

question in our minds, was this intended to benefit an investor? 

There are some circumstances, of course, Mr. Chairman, in which 

it is appropriate to make fulsome disclosure of portfolio information 

to a ratings agency under circumstances where a ratings agency 

would agree to keep the information confidential. 

The responses we got did not give us that assurance that the disclosure, on a selective basis of portfolio information, was done 

under circumstances with appropriate confidentiality agreements 

in place. 

Senator FITZGERALD. If someone uses the material, nonpublic information, given to them from a mutual fund to trade in the mutual fund’s shares, would that be a crime? 

Mr. CUTLER. I think that would be a violation of the central provision of the Federal securities laws, Section 10(b), the anti-fraud 

provision, and any violation of the Federal securities is also potentially a criminal violation. We, at the SEC, do not have criminal 

23

jurisdiction, but, yes, indeed, it is potentially a subject of criminal 

prosecution as well. 

Senator FITZGERALD. Getting to the bottom line here, we are 

talking about serious wholesale criminal violations coming to light, 

are we not, Mr. Cutler? 

Mr. CUTLER. Again, I am loathe to pre-judge until we have done 

a more complete investigation, but I certainly share your concerns 

100 percent. 

Senator FITZGERALD. Mr. Roye, you are in charge of the policy 

development; is that correct? 

Mr. ROYE. That is correct, Senator. 

Senator FITZGERALD. You have a lot of good ideas about how we 

can fix specific problems that have come to light in the investment 

industry, such as the late trading, and market timing and so forth. 

But at the end of the day, is it not becoming apparent that there 

is just so much abuse going on out there, and we are treating so 

many problems, and as soon as we treat some of these problems, 

new problems are likely to arise? Do you not think it is time we 

need to reassess how mutual funds are governed to make sure that 

the directors’ interests are better aligned with those of their fund 

shareholders? 

Mr. ROYE. I would agree with that statement. I think that we 

have been sidetracked, if you will, by the latest series of matters 

that have come to light. The Commission for several years has been 

engaged in an effort to try to strengthen, as I outlined in my oral 

statement, the mutual fund governance framework. 

And again we spent a lot of time responding to both Congressman Baker and Ranking Member Kanjorski, on the House side, in 

terms of identifying issues. They sent detailed information requests 

to us. We outlined a number of issues that we were concerned 

about, and we were pleased to see a lot of the initiative that was 

reflected in the bill that Congressman Baker put forth in the House 

Financial Services Committee, and the Commission largely endorsed that. 

But I think that it does point up, and as has been outlined, the 

number of issues that we are having to deal with from breakpoints 

to sales practice issues and some of the issues that Steve pointed 

to, in terms of proxy voting violations, valuation issues that go beyond the pricing issues. 

We need to focus on those issues, and you are right, we can write 

rules, but a lot of these rules and a lot of the practices are already 

illegal, as has been outlined, and it calls for a collective effort, from 

an enforcement standpoint, to hold wrongdoers accountable and 

then perhaps structural changes to enhance the oversight of the industry. 

In connection with our compliance rule proposal, we asked for 

comment from the public as to other private sector initiatives that 

the Commission might pursue to bolster its oversight of the industry. We asked questions about whether or not there should be a 

self-regulatory organization for the industry. We asked whether or 

not there were additional things that auditors could do in the scope 

of auditing funds. Should we have third-party independent compliance reviews of funds? We asked those questions and asked for 

comment. 

24

We supported an increase in the percentage of independent directors. We pointed out that there were gaps in the definition of who 

an independent director can be on funds and pointed out the problems with that. So I think there are fundamental issues that we 

have to grapple with. 

Senator FITZGERALD. Mr. Spitzer, you have looked carefully over 

the last few months at the Investment Company Act. What do you 

think about it, in general, since we have all of these conflicts of interest between the investment managers and the fund directors? 

And what do you think should be done with respect to the Investment Company Act, specifically? 

Mr. SPITZER. I agree with your initial critique of it in your opening statement; that it is not only porous, but it makes Swiss cheese 

look like a solid wall, that there are clearly dynamics that have 

emerged over the past few decades that were not contemplated by 

those who enacted the statute. There has been, at its most basic 

level, a complete failure of the fiduciary obligation on the part of 

those who sit on the boards. Some of this can be traced back to the 

statute. We want to redefine who the governing entities must be, 

can be, who the individuals who serve on those boards should be, 

and I think this calls for the sort of legislative solution that you 

have outlined in your opening statement. 

It must be revisited. The governing structure of the mutual fund 

industry needs to be reexamined from the very top. 

Senator FITZGERALD. Now, the Investment Company Institute is 

going to testify in the next panel. Many in the fund industry might 

say that the interests of the investment adviser are aligned largely 

with the interests of fund shareholders. Because if the advisory 

firm is charging too high a fee, for example, to the fund, then the 

returns will not be that good. Ultimately the fund will not grow as 

rapidly as it otherwise might, and therefore they will not gain business. They are going to have to treat their fund well or their own 

business is not going to grow. 

What would you say to that critique? 

Mr. SPITZER. Well, sometimes good logic still gets you to an illogical conclusion. I think the logic is not necessarily flawed, but the 

problem is that if you look at the track record, what you see is that 

virtually, there is no evidence that boards actually reconsider who 

the adviser should be, who the fund managers should be. Because 

the boards have been chosen by the managers and the advisers 

themselves, the boards never ask the hard questions and, in fact, 

say to a fund manager or to an adviser, we are getting rid of you. 

We are switching our funds elsewhere. 

In addition, what we have found, and I think this is where the 

gamesmanship of the past year fits in, what we have found is that 

fund advisers and fund managers have found other ways to increase their own compensation. They can increase the funds undermanagement by striking deals with market timers to get sticky 

funds into various funds, to let them lie fallow in those other funds, 

therefore, increasing their own compensation, even if the returns 

are not sufficient. And the reason the insufficient returns do not 

trigger their dismissal is the boards have been complacent. 

The common thread that runs through the mutual fund industry, 

that has run through the entirety of the scandals that exploded 

25

over the last several years from Tyco, WorldCom, Enron, on down 

to the issues we dealt with, with research analysts on Wall Street 

has been board complacency—boards that simply do not rise up to 

the task with which they have been charged. 

And the issue that I think faces the Congress and your Subcommittee is how do you craft a statute that will reinvigorate those 

boards to get them to actually challenge investment advisers and 

fund managers to do what has to be done? 

Senator FITZGERALD. You have on your books in the State of New 

York the Martin Act, which goes back to, I think, 1921, and it is 

thought to be the broadest securities law on the books anywhere. 

In enforcing the Martin Act, do you view as illegal when a mutual 

fund allows an investor to have market timing capacity? 

The SEC has testified that a large percentage—I think you said 

50 percent—of the mutual funds have disclosed an arrangement 

with someone that gives them market timing capacity. It is not 

clear to me, under Federal law, whether merely giving someone 

market timing capacity is a crime. Do you believe it is a crime 

under the Martin Act? 

Mr. SPITZER. The answer is it depends. I believe it is a violation 

of the fiduciary duty that a board and a manager have to protect 

the interests of their shareholders. 

Senator FITZGERALD. Well, they have that duty under State 

law——

Mr. SPITZER. Under State and Federal law. 

Senator FITZGERALD [continuing]. And Federal law. 

Mr. SPITZER. Absolutely. 

Senator FITZGERALD. So, if it is a violation of the fiduciary duty, 

would it not be a violation of the Investment Company Act? 

Mr. SPITZER. I believe that it is a violation of their fiduciary duty 

and therefore violative of the law. That is correct. Now, we can 

parse it a bit more carefully because there are disclosures that are 

made by mutual funds in their prospectuses that address the issue 

of market timing, and one has to examine, theoretically, those prospectus statements to determine whether or not the behavior that 

the entity, the fund, undertook violates that prospectus. 

Senator FITZGERALD. Can a disclosure that they allow market 

timing trump a fiduciary duty to treat all fund shareholders the 

same? 

Mr. SPITZER. It cannot trump a fiduciary duty, but if there is a 

specific disclosure that says there will be those who try to market 

time, we will do our best to prevent it, but will not be able——

Senator FITZGERALD. Well, it is essentially then a disclosure that 

we are going to give somebody preferential treatment. 

Mr. SPITZER. No. If they fail to catch somebody, perhaps they are 

not violating their fiduciary duty. If they knowingly permit and 

then accept compensation for permission to time, then there is no 

question in my mind they are violating their fiduciary duty, violating the law and will be charged if they are caught. 

I have added the component of payment and knowledge, which 

I think is—knowledge I think everybody would agree you could not 

charge them without knowledge. Payment we take as perhaps the 

final push over the edge. 

26

Senator FITZGERALD. I am going to turn it over to my colleagues 

to ask questions, but I just wanted to see if either of the witnesses 

from the SEC would care to comment on that issue. 

Mr. CUTLER. Sure. I think Mr. Spitzer is right insofar as you can 

certainly overcome, in my mind, a prospectus disclosure if you can 

also establish that the adviser personally benefited from the arrangement, and where we can show that, where we can show it 

was not a matter of one slipping through the nets, but that there 

was an advantage taken——

Senator FITZGERALD. Are they not getting fees every time there 

is trading? 

Mr. CUTLER. Of course, they are, but it depends on the type of 

arrangement that is reached. And we are obviously looking at all 

of these very hard. 

You start with the prospectus disclosure, but you do not end the 

analysis there. 

Senator FITZGERALD. Well, thank you. 

I would like to turn it over to Chairman Collins to ask questions. 

Chairman COLLINS. Thank you, Senator Fitzgerald. 

Mr. Roye, Mr. Bogle noted in a recent interview that there is an 

old saying in corporate America, and that is, ‘‘When you have 

strong managers, weak directors and passive owners, it is only a 

matter of time before the looting begins.’’

I want to talk to you about the role of the boards of director and, 

in particular, about the possibility that the directors are not doing 

an effective job because they are so overcommitted. They are serving on so many different boards within a family of funds. 

In looking at the SEC filings, I noticed that there is tremendous 

overlap among the boards of directors in fund families. There are, 

in fact, plenty of fund family directors who serve on the boards for 

80 or even 90 different funds, which seems too many to me. 

The Chairman of Bank of America’s Nation’s Fund sits on the 

boards of 85 funds. The Chairman of Janus sits on 113 fund 

boards. Now, I realize that many of the funds have similar structures and approaches. So there may be some economies of scale, if 

you will, but it is hard for me to see how anyone, any one director, 

could effectively monitor the activities of so many different entities. 

Is the SEC taking a look at this area as far as issuing guidelines 

to limit the number of boards that a director can serve on within 

the same family of funds? 

Mr. ROYE. I think you point out real limitations in terms of director oversight. I think every director who serves on a mutual fund 

board, who is in a mutual fund complex, has to ask him- or herself 

whether or not they are effective. 

You point out that there are directors who sit on multiple fund 

boards. As you indicate, there are common issues between funds. 

When you get into issues like how they are sold, and how their 

transfer agent is operating, a lot of those issues are the same for 

every fund. So, once directors ask questions about those types of 

operations, the answers apply really across the board to all funds. 

Of course, when you get to particular funds, you get into different 

investment objectives, policies, different portfolio managers, different performance, and you get into individual issues with regard 

to each fund. 

27

But I think you are right in that there is a limit, and I think 

the problem that we have, as the government, is prescribing exactly what that limit is. To this point in time, I think what we have 

done is look to the directors to exercise that judgment. 

And there can be benefits of serving on multiple boards in the 

sense that issues come up, problems come up, and you can make 

sure that those issues do not creep into your other funds where you 

see a problem in one fund and directors sitting on common boards 

can benefit from that information flow. 

But I think you are right, that there is a limit, and I guess the 

question is, from the standpoint of the government, what should 

our role be? What is the right number of funds to effectively oversee? And to this point, we have looked to the directors to make that 

judgment. 

I know that the Investment Company Institute, in its best practices for fund directors, has recommended that directors do a selfevaluation periodically to assess whether or not they are effective, 

are they organized the right way. I think that we try to get a sense 

of that when we go in and do examinations, looking at their committee structures and how they function. But to this point, we have 

not gone down the path of coming up with what is the right number. 

Chairman COLLINS. I would note that there are also monetary 

issues at work here. It is very lucrative if you are serving on many 

of these individual boards, and given the pattern that we have seen 

of lax oversight, widespread abuses and the lucrative incentives to 

serve on as many boards as you possibly can, I think this is an 

area that the SEC really needs to take a hard look at. 

I cannot imagine how individual directors, serving on 80, 90, 

even 100 boards, even if they have a lot in common, can be doing 

a truly effective job, and yet those directors are well compensated 

for serving on each of those boards. So I would encourage the SEC, 

as you take a look at the issue of whether or not there need to be 

more independent directors, to also look at whether directors are 

overcomitted and not able to exercise effective oversight. 

Mr. ROYE. Let me just add that, in terms of director compensation, this is an area where we have forced disclosure of how much 

directors are paid so that investors can make judgments about that 

compensation. 

I think this is also an area where, at the SEC, when you talk 

about the regulatory framework and the statute, we have certain 

authorities where we can act. And, indeed, as I outlined how the 

rulemaking tried to require a majority of independent directors, 

self-nominating directors, independent legal counsel, when we advanced issues like that through rulemaking, there were people who 

told us that we were exceeding our authority to do that, and so this 

might be an area where we may need some legislative help in 

terms of addressing an issue like you outlined. 

Chairman COLLINS. Thank you. 

Mr. Cutler, you explained to us that the SEC receives thousands 

of tips from the public and that it is difficult sometimes to sort 

through those, and it may be difficult to identify ones that are 

worth following up on, but the SEC has another I would argue far 

28

more effective tool to use, and that is the examination and audit 

process. 

I would like to know, first of all, whether you believe that the 

current audit schedule is adequate to enforce the law. I know mutual funds have to register with and regularly report to the SEC. 

They must submit to regular audits and examinations by the Commission staff. I am wondering why these problems were not revealed through the examination and audit process. 

Mr. CUTLER. And I do not oversee that process, but let me do my 

best to address your question, Senator Collins. I think it is a very 

fair question. 

I know that in recent years the SEC could examine funds and 

fund advisers only once every 5 years. There are over 6,000 mutual 

funds in our country and over 7,000 advisers, and so there are 

some resource constraints here at issue. As recently as 1994, I am 

told, the average frequency for examining advisers was once every 

22 years. So that number has come way, way down. 

With the additional resources that I know that you were instrumental in helping us to get, Senator, in the last few months, we 

have moved towards a cycle of every 2, 4 or 5 years for advisers 

and funds based on the level of risk posed by the individual firms. 

And as we absorb new staff, I know that our Office of Compliance 

Inspections and Examinations will be continuing to evaluate 

whether the cycle should be further reduced. But you are absolutely right. Examinations have to be a key component to how the 

agency gathers intelligence and understands what is happening out 

there in the industry. 

Chairman COLLINS. Thank you, Mr. Chairman. 

Senator FITZGERALD. Senator Akaka. 

Senator AKAKA. Thank you very much, Mr. Chairman. 

The testimony this morning has indicated that there is serious 

abuse out there. There is a need to take steps to stop the abuse 

and restore investor confidence. 

Mr. Cutler, on page 2 of your statement you indicate that the 

SEC’s second area of focus is on sales practices. You pose a question about customer understanding of revenue sharing and shelf 

space payments. What have you learned about consumer understanding of these relationships, and what is necessary for investors 

to be able to make informed decisions? 

Mr. CUTLER. Well, from my perspective, and it is an enforcement 

vantage point, as opposed to a regulatory vantage point, I have 

seen at least one significant matter in which—and there are 

more—but one that is on the forefront of my mind where it is clear 

to me that customers did not have a fulsome understanding of 

what it was that the broker who was selling them the product was 

getting out of that sale. And it strikes me that that is the fundamental question we all have to ask. When someone recommends a 

transaction to you, Senator, you have a right to understand that 

the person recommending that transaction to you, the firm recommending that transaction to you has an interest and that they may 

have gotten a payment, if you will, to feature that recommendation. 

You mentioned shelf space, and I think that is the right terminology. We have learned of many situations in which funds were 

paying the brokerage community to feature their product on a preVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
29

mier shelf, and it strikes me that investors deserve to know that 

sort of incentive has been created. 

Senator AKAKA. Thank you. Let me shift to the other side of the 

panel. 

Ms. Schapiro, you mentioned that you are conducting an examination sweep of brokers and dealers to determine how investment 

companies pay to be included on firms’ featured mutual fund lists 

and why they receive favorable promotional or selling efforts. 

What have you learned so far about these relationships during 

the sweep? 

Ms. SCHAPIRO. Thank you, Senator. 

Well, we are, in fact, conducting a sweep focused on 12 major 

broker-dealers to determine how they have been paid by funds for 

inclusion on a preferred or recommended list, and as I said, we are 

looking at all different kinds of broker-dealers—on-line firms, discount firms, full service and fund distributors. 

Clearly, we are in an environment where there are so many mutual funds who are vying for visibility in the distribution chains 

that they are willing to pay a broker-dealer or direct brokerage 

commissions to a broker-dealer in return for appearing on that preferred or recommended list. It is a clear violation of NASD rules. 

We will announce some cases very shortly and, as I said, we have 

an examination sweep ongoing in that area as well as in a number 

of other areas. 

If I can harken back to your question to Mr. Cutler, the concern 

about investors understanding fees and expenses I think underlies 

many of the problems we have here. There is a lack of clarity in 

the disclosure. Investors have to go multiple places to find out 

about things like directed brokerage, soft dollars, expenses, frontend sales loads, contingent deferred sales charges, many things you 

all have referenced in your opening comments. 

We need to have disclosure that is concise and in one place so 

that investors understand what they are paying for with all of the 

fees and expenses, what reduces their initial investment and what 

the impacts are on their return as a result and, as well, what are 

the conflicts that compensation practices create for brokers that encourage them to sell one product over another because it benefits 

the broker and not necessarily the investor? 

Senator AKAKA. Mr. Galvin, let me pursue soft dollars. In your 

statement, you state that soft dollars should be banned. 

Mr. GALVIN. Yes. 

Senator AKAKA. Please explain to the Subcommittee why you believe it is necessary to ban the use of soft dollars. 

Mr. GALVIN. Well, I think oftentimes soft dollars are places that 

funds develop additional sources of revenues and fees that really 

ultimately end up coming out of the consumer, but are hidden from 

them—I think just what Ms. Schapiro was describing, the complexity of an individual confronting a broker to find out what it is 

actually going to cost them. 

I think we have to put this all in context, especially in mutual 

funds. Mutual funds are where people go for a sense of safety. Oftentimes, people who go there are either unsophisticated or choose 

not to be sophisticated. They want a simple transaction. They want 

some protection, and they ought to know what the fees are. They 

30

ought to know what the costs are. And I think the good part of the 

disclosure provision of the current bill, H.R. 2420, is good, but I 

frankly think they ought to be banned because I cannot see a basis 

for where does the benefit go to consumers that soft dollars are still 

part of the system. It is complex enough without dealing with soft 

dollars already. Why can we not make it more clear? I think we 

need to draw bright lines. 

One of the difficulties, and I think it is apparent here, as we 

have all been grappling with these various terminologies is, although it is a simple concept, mutual funds, it is very complex 

when you try to explain it to people, and we all have some idea 

what we are talking about. Imagine the average consumer that is 

confronted or trying to understand exactly what is going on. 

I think we have to somehow codify a sense of ethics, a catch-all 

for the industry so that there will be the opportunities so that we 

will not be having to think twice or three times whether something 

that is clearly unethical is also criminal. 

One of the things we saw for instance in the sales practices 

issues at Morgan Stanley was the complete failure to disclose any 

sales contests, huge bonuses to office managers, deferred compensation. Imagine, for a minute, Senator, if I were your broker 

and said to you, ‘‘I recommend you buy this product, but before you 

buy this product, Senator, I want to tell you I am getting more 

money to sell it to you. My deferred compensation has improved, 

and I am entered in a trip, and I can go to some nice place, but 

that had absolutely nothing to do with my decision to recommend 

this product to you.’’ I think you would ask me some other questions, and yet I do not think that individuals get the benefit of 

that, and that is the problem. 

Senator AKAKA. Mr. Spitzer, following up on soft dollars, what is 

your evaluation of the use of soft dollars, and do you agree with 

Secretary Galvin’s assessment that they should be banned? 

Mr. SPITZER. I am not yet at the point where I wish to make that 

bright line or statement. We have not been investigating the soft 

dollar issue in particular. We have been having enough fun tracing 

the hard dollars, and we found those flowing to more interesting 

places. 

There have been so many opportunities for fraud and misconduct, and I think the numbers that Steve revealed in his testimony, in terms of the frequency of abuse, make that clear. We have 

been looking at the overall structural relationships among the parties and trying to clarify to the consumer what the problems were. 

In answer to your question before, what have we learned from 

our inquiry, the first thing I learned is the companies do not want 

us to look; the second thing we learned was that they will try to 

hide the evidence occasionally; the third thing we found is that 

when we finally get the E-mails, it is not a pretty picture. And the 

end result is that we have opened up a window into a morass of 

conflicts of interest, not only the soft dollars, where I have no reason to disagree with Bill’s conclusion, but I am not yet at the point 

where I have studied the issue sufficiently to say outright ban 

them. I think inquiry needs to continue. 

But what is eminently clear is that this is a window into what 

has been foggy, murky and impossible to understand. And if you 

31

think about, to draw an analogy, somebody mentioned shelf space, 

which you think about in a supermarket context most often, when 

you pick up a product at the supermarket, it has a nice little chart 

on the back that gives you your nutritional information, which 

Congress thought was an appropriate type of disclosure for folks so 

they would understand what they are eating, what they are buying. And we have rules about pricing, common pricing among 

equally weighted products, things that have worked well for consumers. 

We do not have those rules for mutual funds. There is no capacity to seek comparability in the examination of costs, returns, and 

what you actually pay. That is what I think the consumer is owed 

and what we are demanding. 

Senator AKAKA. Thank you. Let me continue to pursue the issue 

of soft dollars and ask Mr. Roye and Mr. Cutler about their use. 

The SEC released a study on soft dollars in September 1998. The 

report indicated that soft dollars were used to pay for research, salaries, office rent, telephone services, legal fees, entertainment, 

among other expenses. What trends, if any, in the use of soft dollars have you seen since a report was issued? 

Mr. ROYE. I will respond to that. 

You are correct, the Commission examination staff did a study 

of soft dollars and made a series of recommendations in that area 

to improve disclosure, improve transparency. Indeed, we have some 

follow-on proposals that are pending in that area for investment 

advisers. 

I think, as was pointed out again in the Baker legislation, the 

Commission endorsed the reexamination of the soft dollar area. It 

does introduce conflicts. You know, managers generating commissions to produce benefits, they could be research benefits, they 

could be nonresearch benefits, and the way the statute works is 

that they are protected if they gained research for that, but if it 

is outside the research definition, it could be problematic, even unlawful. 

Indeed, Steve’s group has brought enforcement actions against 

some investment advisers for violations of soft dollars and soft dollar abuses. So we still see abuses in this area, but it is an area 

where conflicts are introduced, and they have to be managed, at 

the very least they have to be disclosed, and we have endorsed the 

reexamination of that. 

It is a complicated issue in the sense that if you ban soft dollars, 

the way some have argued, you get into issues of how research is 

paid for? Mr. Spitzer, Steve, the Commission negotiated a settlement of the research analyst matter. A lot of that research that is 

provided by independent research analysts is paid for in soft dollars. So it is a very complicated issue, but I think it is one worthy 

of further examination. Indeed, they are looking at it in the U.K. 

currently and deciding what approach they are going to take on 

soft dollars. 

Senator AKAKA. Thank you very much. 

Senator FITZGERALD. Senator Akaka, thank you. 

All of you, you have been wonderful witnesses. Thank you so 

much for being here. 

32

We are going to move on. Actually, Congressman Baker is here 

now. He has arrived in Washington, and if the second panel would 

just hold back for 1 minute so we can let Congressman Baker give 

his statement, we will then take a 5-minute break and reconvene 

with the full second panel. 

Thank you all for being here. You have been terrific witnesses. 

Thank you. 

Congressman Baker, thank you very much for being here. I know 

that you have a full schedule, and we are happy to accommodate 

you at this time. While you were gone, Senator Akaka and I both 

commended you on the extraordinary leadership you have shown in 

attempting to reform the mutual fund industry, and I likened you 

to John the Baptist as a voice crying out in the wilderness. You, 

like John Bogle, had been talking about this issue for years. You 

introduced a wonderful bill before the current scandals came to 

light. 

Congressman Richard H. Baker is from the Sixth District of Louisiana. He is Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises. That includes Fannie Mae and Freddie Mac, and 

that is a whole other area in which that we have had hearings. 

Congressman Baker introduced H.R. 2420, the Mutual Funds Integrity and Fee Transparency Act of 2003. I believe you introduced 

that in June of this year. This bill would help investors gain a 

clearer understanding of the fees they are charged for investing in 

mutual funds and strengthen the role of independent directors who 

are charged with guarding the interests of fund investors. 

He has also been a leading advocate of regulatory reform in the 

securities industry and is working tirelessly to restore investor confidence. 

I also want to take this opportunity to recognize the year-long effort of the House Financial Services Committee to reform the mutual fund industry. Led by Chairman Oxley and Subcommittee 

Chairman Baker, long before any scandals came to light, the Financial Services Committee has brought the issue of mutual fund 

reform to the forefront. 

My Subcommittee will continue to collaborate with the House Financial Services Committee on this and other important issues facing the securities industry. 

Congressman Baker, I welcome you to the Senate and thank you 

for making the time to participate in this hearing. You may proceed with your statement, and I understand you just flew into 

Washington this morning. Is that correct? 

Mr. BAKER. Yes, sir, that is correct. 

33

1The prepared statement of Mr. Baker appears in the Appendix on page 120. 

TESTIMONY OF HON. RICHARD H. BAKER,1 A REPRESENTATIVE IN CONGRESS FROM THE STATE OF LOUISIANA, CHAIRMAN, SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE 

AND GOVERNMENT SPONSORED ENTERPRISES, COMMITTEE 

ON FINANCIAL SERVICES, U.S. HOUSE OF REPRESENTATIVES 

Mr. BAKER. I appreciate the gentleman’s very gracious introduction, and I would perhaps characterize my efforts slightly differently. My dad told me if you hang a tie in the closet and leave 

it there long enough, sooner or later it will come back into fashion. 

And I kind of feel like I have been hanging in the closet for a long 

time and events have just changed. But I do appreciate very much 

your interest in the subject and your leadership here in the Senate 

in providing direction. I look forward to working with both of you 

as we move forward on this difficult subject. 

When the bill was introduced, there really was not a crisis. I was 

merely directing attention to the difficulty in understanding what 

it is that working families get at the end of a year when they get 

that mutual fund statement and sit down at the kitchen table and 

try to figure out where the money went. 

My son, who is doing better in life than I, had two different 

funds, and came to me, the smart guy, to help him understand. 

After a bit of embarrassment, I determined that I needed to go to 

school and try to understand how this reporting system was intended to work. That led to a number of other observations that I 

thought would be in the best interests of working families. 

As the Senators know, 95 million Americans now invest in mutual funds, over half of all households, virtually everyone, through 

the workplace or through some other opportunity, is a direct investor in this great economy, and that is as it should be because those 

investors now, in such large number, provide enormous capital for 

business expansion and job opportunities. So it is important we 

have a system that functions properly—one that they feel they are 

being treated fairly. 

I also want to speak to the work for a moment of that of Attorneys General Spitzer and Galvin. Although we have had disagreements on other substantive issues, I think their work in pursuit of 

wrongdoers in the mutual fund industry is outstanding and highly 

appropriate. 

In only one example of Mr. Galvin’s work, there was a group of 

New York State union officials, apparently, who had access to information and each afternoon would engage in market timing 

events. Ten such individuals engaged in over 3,000 trades over a 

3-year period. It became known within the mutual fund company 

that facilitated the trades as ‘‘the boilermaker hour.’’ That type of 

conduct is so egregious it is hard for one to imagine how it could 

be endured by those in a professional position of responsibility as 

fiduciaries of working families’ money. 

With the introduction of H.R. 2420, there are a number of elements to the bill which I will quickly recite and concentrate only 

on one or two that I think warrant a little discussion. 

34

We enhanced fee disclosure. We require enhanced portfolio manager disclosure of compensation and their holdings. We try to make 

sure that the breakpoints, those discounts you earn when you buy 

more of the shares, are given appropriately, disclosure of revenue 

sharing agreements, portfolio transaction expenses. This is something that I think deserves a great deal of attention. 

That is how frequently the shares or the stocks held by the fund 

are bought and sold. Some call it churning. On average, a fund will 

hold a stock now for only about 11 months. It certainly adds a new 

perspective to long-term investing. 

There is a fund, Fred Alger Management Fund, with assets of about $2 billion for the year 2002, had $9 billion of redemptions in 

a single year, for a turnover rate of 440 percent. One has to question the legitimate purposes for such a high level of turnover, and 

there are many who have in excess of 100 percent of turnover, disclosure of directed brokerage arrangements, disclosure of the soft 

dollar arrangements, and some attention has been given by the 

first panel to whether soft dollar arrangements should be made illegal entirely. Almost as to refocus the debate a bit, whether it is 

a good thing or a bad thing, we at least ought to know about it, 

but more importantly, the scope of soft dollar problems fades in far 

less importance when you are looking at the broader picture of mutual fund mismanagement. 

And so I would hope that we not let that issue cloud the judgment on the broader array of reforms which are really warranted. 

Enhanced Audit Committee requirements, a simple thing. A no 

load fund ought to be no load. Today, you can have up to 25 basis 

points of 12b–1 fees assessed, and you still maintain the title ‘‘No 

Load Fund,’’ even though you do not know that you are paying that 

fee. 

I would like to focus a little bit on things that are not in the bill. 

I think we made a good start, but I do not believe we have got it 

all right, and this is where I think the members of this panel can 

be very helpful. 

I waged a valiant effort, but in the end lost, on the importance 

of an independent chair for mutual fund governance. Most investors do not really get the real picture of what the chairman of the 

mutual fund’s responsibilities are as the CEO of the management 

company. 

The board hires the management company to come in and run 

the investment portfolio of the mutual fund company. The mutual 

fund is owned by its individual shareholders—the moms and pops. 

The management company is also owned by shareholders, but it is 

a different group of shareholders. 

The two goals of those two companies are different. The mutual 

fund company wants to make as much money as possible by limiting the payments to the management company. The management 

company shareholders want to make as much money as possible by 

making fees from the mutual fund. 

I think it incredibly important, particularly given the operational 

professional judgments that have been absent in far too many cases 

for the chairman, and with the addition of a chief compliance officer who would report only to the independent chairman, to have 

the authority to determine if the management company is perVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00038 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
35

forming its job in a manner appropriate for the shareholders of the 

mutual fund. Imagine how hard it must be for those individuals 

who are CEO of the management company, as the chairman of the 

board of the mutual fund, to fire themselves from their own contractual relationship. 

It seems to me to be a clear-cut conflict of interest, and so I 

would heartily recommend the Subcommittee revisit that issue. 

There should be a clear and explicit prohibition, although I believe it to be a violation of insider trading provisions, to preclude 

market timing in their own funds. There should be a prohibition 

that makes it impossible for a manager to simultaneously operate 

a mutual fund and a hedge fund. Hedge fund payments to management tend to be a bit more lucrative than those payments made by 

a mutual fund because of the risk engaged in operating a hedge 

fund. 

There is a case where a manager was market timing his mutual 

fund for the benefit of his own hedge fund. That behavior is, if not 

criminal, certainly ought to be soon. 

Another issue is whether any mutual fund at all should be permitted to utilize market timing as a management tool. I question 

the validity or benefit to the shareholders of such action. 

I believe there should be clear, concise disclosure of executive 

and portfolio manager compensation. Simply stated, are they investing in the funds just like the shareholders for whose money 

they are charged with the responsibility of managing, and how 

much do they make at your expense? This is the case for all Fortune 500-traded publicly operating companies. Mutual funds should 

be no different with that enhanced disclosure. 

Mr. Chairman, I think your work is creating a unique opportunity for us in the Congress, but it is in recognition of our significant responsibilities on behalf of those 95 million investors. Many 

had dreams of early retirement, of buying that special home, perhaps of putting the kids through school or college, and those plans 

have been dramatically restructured. 

Now, almost every investor in the market has felt discomfort 

over the past several years, but the reasons for the financial loss 

were clearly printed on the front page of the newspaper. We did 

not like it. We all understood it, and we accepted our losses. 

However, in my opinion, significant amounts of money have also 

been taken from mutual fund shareholders that they do not know 

they are losing. It is not clearly illegal acts that the attorneys general are pursuing that cost shareholders money. It is the legally 

permissible conduct that is simply not disclosed. Providing investors with a clear, concise statement of the investing facts is all that 

is really required. 

Mutual funds can be a very helpful tool for financial security, but 

not all mutual funds are equal. About 80 percent of all mutual 

funds in a given year underperform the stock market’s S&P 500 

index, and the average actively managed stock mutual fund returns about 2 percent less to its shareholders than the stock market returns in general, and fees matter, as Mr. Bogle, I am sure, 

will visit in a moment. 

A $10,000 investment for 20 years, with an average annualized 

return of 12 percent, you will get dramatically different results 

36

with just a small change in administrative expenses. With a halfa-percent rate, your investment net is about $87,000. With a full 

service 2 percent fee charge, your investment is worth about 

$64,000. The only variable is the difference between a 2 percent 

management fee and a half-a-percent fee, and that equates to 

$22,862. Fees do matter. 

Whether a particular mutual fund meets your needs should be 

an informed decision every investor should make based on the facts 

and full disclosure. In the capital markets hearing back in March 

of this year, one of the industry representatives said it very well. 

‘‘Investors then are fully informed and free to make their own decisions about whether a fund offers the right combination of investment performance and service that justifies the fee being charged 

or not. As in any competitive, free-trading market, the ultimate 

power rests, as it should, with the judgment and wallets of mutual 

fund shareholders.’’

That is the way it should be, and I believe there are many within 

the industry, and certainly many within the Congress, who want 

to work together to structure a marketplace that works that way. 

Unfortunately, I have come to the conclusion it is not working that 

way at all. 

With your leadership, Mr. Chairman, and the assistance of the 

Members of your Committee, I think we can provide a blueprint for 

what the industry says it wants to build, and that is a mutual fund 

marketplace that is fair to all, based on complete disclosure of the 

investing facts, with rules applied equally to everyone. 

Thank you, Mr. Chairman. 

Senator FITZGERALD. Congressman Baker, thank you so much for 

coming over here, and, again, we want to commend you on the outstanding job you have been doing. We hope to work with you in the 

future. Senator Akaka has a bill that he has prepared that would 

help reform the mutual fund industry along the lines of the bill you 

have introduced in the House, and I intend to work with Senator 

Akaka as we pursue bipartisan legislation in the Senate that would 

mirror the reform efforts you have begun in the House. 

We wish you good luck in your pursuits over there because I 

know we are fighting against a very powerful industry. There is actually an old phrase that a Chicago alderman once said. His name 

was Paddy Bauler. And back in the 1950’s, he famously observed 

that ‘‘Chicago ain’t ready for reform.’’

Well, I am not sure the mutual fund industry is ready for reform 

yet, but whether it is ready or not, it needs to be reformed. And 

so I thank you and look forward to continuing to work with you. 

Thanks for coming over today. 

Mr. BAKER. You are very kind and generous with your remarks. 

I look forward to working with you gentlemen as well. 

Senator FITZGERALD. Thank you. 

Senator AKAKA. Mr. Chairman, I also want to add my gratitude 

to Congressman Baker for your leadership in this effort. I look forward to working with you as well. Thank you. 

Mr. BAKER. Thank you, Senator. 

Senator FITZGERALD. At this time we would like to take a very 

brief 2- or 3-minute break so everyone can stretch. Then we will 

reconvene with the second panel. Thank you. 

37

[Recess.] 

Senator FITZGERALD. I would now like to introduce our next 

panel of witnesses. 

John C. Bogle is the founder and former CEO of the Vanguard 

Group and the President of Bogle Financial Markets Research Center. He created Vanguard in 1974 and served as Chairman through 

1997 and Senior Chairman through 1999. Mr. Bogle has received 

a number of awards and distinctions for his leadership at Vanguard, which is one of the two largest mutual fund organizations 

in the world and the first organization to offer an indexed mutual 

fund. If I am not mistaken, Vanguard is the only mutual fund 

where the funds actually own Vanguard. 

Mr. BOGLE. That is correct, Mr. Chairman. 

Senator FITZGERALD. Mr. Bogle is also the author of four books 

on investing and mutual funds. 

Also with us today is Mercer E. Bullard. Mercer Bullard is the 

founder of Fund Democracy, a nonprofit membership organization 

that serves as an advocate and information source for mutual fund 

shareholders and their advisers. Mr. Bullard is also an Assistant 

Professor of Law at the University of Mississippi, where he teaches 

in the areas of securities and banking regulation, corporate finance, 

and contracts. Mr. Bullard was formerly an Assistant Chief Counsel in the SEC’s Division of Investment Management, where he 

was responsible for a wide range of matters involving mutual funds 

and investment advisers. 

Matthew P. Fink is the President of the Investment Company Institute, the National Association for the American Mutual Fund Industry, representing over 8,600 mutual funds across the country. 

Mr. Fink has been with the Investment Company Institute since 

1971 and has served as its president for the past 12 years. 

Again, I would like to thank all of you for being here today to 

testify. In the interest of time, we would ask that you submit your 

written statements for the record. They will be included in full as 

part of the record. And we would ask that you try as best as you 

are able to summarize your remarks for the Subcommittee in a 5-

minute opening statement. 

Now, I am informed that Mr. Bogle needs to leave this building 

at 1:30 so we can get him on a train out of town, and we are going 

to try and keep that commitment to Mr. Bogle. 

Mr. Bogle, we may begin with you, and I mentioned in my opening remarks that Vanguard, as I understand it, is the only fund in 

the country that is set up in a truly mutual way in which the fund 

owns Vanguard. In all other instances of mutual funds, you have 

a separate advisory firm typically that, I gather, sets up the funds, 

and you set up Vanguard so that the interests of the operators of 

Vanguard were more aligned with the funds. Could you address 

that structure that you have just at the outset? I think it is a very 

important point. 

38

1The prepared statement of Mr. Bogle appears in the Appendix on page 130. 

TESTIMONY OF JOHN C. BOGLE,1 FOUNDER AND FORMER 

CEO, THE VANGUARD GROUP 

Mr. BOGLE. Yes, I am happy to do that. We created an organization in which actually the mutual funds own all of the common 

stock of Vanguard Group, Incorporated, which is our investment 

manager. We operate at cost, and each fund just picks up its own 

proportion, its share of that cost. There is no profit to any outside 

organization. When we actually employ external investment managers, we negotiate with them very vigorously on behalf of the 

funds that they are negotiating with. And, in fact, in some cases 

we get the fees down to less than one basis point—not 10 basis 

points, Mr. Chairman, one basis point. So we not only have the 

ability to run at cost, we have the ability to negotiate at arm’s 

length. 

Senator FITZGERALD. You get the fees for investment management down to one basis point? 

Mr. BOGLE. Yes. I will confess that our equity funds sometimes 

run as high as 10 or even 15 basis points. 

Senator FITZGERALD. Not one point. We are talking basis points. 

One basis point. 

Mr. BOGLE. Yes. Our Ginnie Mae fund is a managed mortgagebacked securities fund, and it has a fee of nine-tenths of a basis 

point, not 10 basis points but less than one basis point. 

Senator FITZGERALD. What kind of a fee does the typical——

Mr. BOGLE. Well, just 0.9 basis points generates a staggeringly 

large fee of—I think it is about $3 million a year. How could anybody possibly spend that much on that kind of management? Just 

think about it for a minute. So we ought to all be looking, by the 

way, Mr. Chairman, at dollar amounts of fees and not fee rates. 

You know, this industry, it is almost as if there was a conspiracy 

many years ago, and they said, What is the biggest number we can 

think of to relate our management fees to? And someone said, How 

about we use all the assets of the fund? So we get this 1.5 or 2 

percent fee, which looks very small, but we do not say that 3 percent all in costs, counting trading costs for equity funds, is 30 percent of the stock market return in a market returning 10 percent 

and actually 100 percent of the equity premium—that is to say, 

stocks usually yield about 3 percentage points more than bonds, 

and at a 3 percent cost in an equity fund, you might just as well 

own a bond fund as a stock fund. It is a staggering large cost. 

Now, if I may move on to my opening statement, first of all, I 

obviously deeply appreciate your incisive and insightful opening 

statements, and I have to say, Mr. Chairman, I am deeply humbled 

by your comments because the only thing I have ever had to offer 

this industry or this world is common sense—I am not a big 

brain—and some sense of trust for other people’s money. It is interesting that my extreme statements of yesterday seem overnight to 

be statements of great moderation, and that which was once heresy 

is now dogma. 

I have been involved in this industry ever since 1951—or 1949, 

when I began to write——

39

Senator FITZGERALD. Could you pull that microphone a little bit 

closer so everybody can hear? Thank you. 

Mr. BOGLE. Yes. I began my involvement with this industry ever 

since 1949 when I began to write my senior thesis at Princeton 

University. In 1951, I went to work with industry pioneer Wellington Management Company and headed that company from 

1965 to 1974, during which period I was also the Chairman of the 

Board of Governors, part of that period, of the Investment Company Institute. It was in 1974 when I founded this new mutual 

fund organization called the Vanguard Group of Investment Companies. 

It is peculiar but true that Vanguard represented my attempt to 

create a firm that would measure up to the goals I set forth for the 

mutual fund industry in that original senior thesis at my university, to place the interests of fund shareholders as the highest priority, to reduce management fees and sales charges explicitly, to 

make no claim of ability to beat the stock market, and to manage 

funds—and this is a direct quote from that ancient thesis—‘‘in the 

most honest, efficient, and economical way possible.’’ And through 

Vanguard, we have done our best to meet those goals, and as a result, Vanguard has become the lowest-cost provider of financial 

services simply by delivering the staggering economies of scale that 

exist in the money management business. In fact, Vanguard’s unit 

costs are down about 60 percent since we began, and the industry’s 

unit costs are up about 60 percent. That is quite a contrast. And 

also with $650 billion of assets, that low-cost theory has enabled 

us, because some investors understand, to become one of the two 

largest firms in this field. 

After I gave up my position as Vanguard’s senior chairman, I 

have been engaged in writing, researching, and speaking about investing in the fund industry and, for that matter, corporate America and the New York Stock Exchange, including half a dozen oped pieces for the New York Times and the Wall Street Journal, one 

of which castigated the industry for taking the position that we 

should not tell our own owners how we are voting their shares, as 

well as several additional books, now four in all, all presenting 

strong and, I hope, well-reasoned views of this industry’s imperative need to better serve its shareholders. 

But I am sorry to tell you, Mr. Chairman, the fund industry has 

yet to measure up to those idealistic yet wholly realistic goals that 

I urged upon the industry back in 1951. 

Disgusting, as they are to someone like me, who has made fund 

management his life’s work, the recent market timing scandals, as 

you observed yourself, sir, have a good side. They call attention to 

the profound conflicts of interest that exist between fund managers 

and fund shareholders, conflicts that arise from an inherently 

flawed governance structure in which fund owners in practice have 

little, if any, voice. The trading scandals are just the small tip of 

an enormous iceberg of conflict. 

While the costs of international time zone trading has been estimated at about $5 billion, the costs of managing the industry’s 

nearly $7 trillion of assets in stock, bond, and money market funds 

came to some $123 billion, counting trading costs, in 2002 alone, 

a cost that is largely—think about this a minute, sir—indeed alVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
40

1The prepared statement of Mr. Bullard appears in the Appendix on page 154. 

most entirely responsible for the reason that mutual fund returns 

fell short of the returns available in the financial markets. Gross 

return minus cost equals net return. It is inescapable and, yes, sir, 

costs matter. 

If the management fees that represent the major portion of those 

costs were subject to arm’s-length negotiation between funds and 

their managers, it is true that tens of billions of dollars could be 

saved and added to investor returns year after year after year. 

The kind of stewardship that demands that fund directors effectively represent the shareholders who elected them and to whom 

they are responsible under the law is rarely found in this industry. 

Rather, managers focus on salesmanship, their agendas dominated 

by a desire to bring in assets under management. That marketing 

agenda led us, as you know, sir, to create hundreds of risky new 

economy funds during the stock market bubble, not because they 

were prudent investments but simply because we thought the public would be eager to buy them. And in the ensuing market crash, 

those very funds cost our shareholders hundreds of billions of dollars, even as fund managers were reaping tens of billions of dollars 

in extra advisory fees. 

The conflicts of interest that engendered these unhappy and costly outcomes for fund shareholders must be resolved, and must be 

resolved in favor of fund owners and not fund managers. 

My formal statement sets forth a series of governance reforms 

that I believe are required to set the balance straight, and I strongly urge you to consider them. 

I want to add just very briefly, let me say that I love the mutual 

fund industry, and I have loved it ever since we first met in 1949. 

But we have lost our way, and we must return to our proud heritage. It is the recent scandals that give us the opportunity to build 

a fund industry that is worthy of our heritage, one that returns to 

what I have been doing and trying to get done a long time, sometimes I think I have been working on it forever: Giving the mutual 

fund industry’s 95 million investors a fair shake. 

Thank you, sir. 

Senator FITZGERALD. Thank you very much, Mr. Bogle. Mr. 

Bullard, you may proceed. 

TESTIMONY OF MERCER E. BULLARD,1 FOUNDER AND 

PRESIDENT, FUND DEMOCRACY, INC 

Mr. BULLARD. Thank you. Chairman Fitzgerald, Ranking Member Akaka, and Members of the Subcommittee, thank you for inviting me to testify here today. 

The occasion for this hearing is for me, and I believe all of us, 

an unhappy one. The U.S. fund industry is in the middle of the 

worst scandal in its history. Shareholders’ faith in the securities 

markets has once again been shaken, this time with respect to an 

industry that has had a relatively scandal-free reputation. 

About this few disagree. About how to deal with this scandal 

there is significant disagreement. Some believe that the scandal involves only a few bad apples, a few isolated instances of fraud, the 

failure of fund rules. In my view, the scandal involves more than 

41

a few bad apples. It reaches into the highest executive ranks of 

some fund managers. It involves a number of different types of 

frauds at a large number of fund complexes. It demonstrates not 

a failure of fund rules but a systemic failure of compliance. 

The alleged frauds were no surprise. They were open and notorious. The most substantial harm to shareholders, harm caused 

when funds used stale prices, has been well known for years and 

exploited by professional and retail investors alike. 

Academics have published numerous studies on stale pricing, estimating that shareholders lose hundreds of millions or even billions of dollars every year. There have been articles describing how 

to exploit stale prices in popular financial press. Three years ago, 

I wrote two articles describing the problem of stale pricing and 

showed how a fund using stale prices could lose 2 to 3 percent of 

its assets because of stale prices in a single day. 

This has not been a problem for some complexes that have chosen to protect their shareholders. Vanguard and Fidelity, for example, among others, routinely fair-value their portfolios to ensure 

that their funds’ prices are not stale. The question for this Subcommittee is why managers and directors of other funds did not 

take steps to protect their shareholders. 

The alleged frauds of late trading, market timing, and commission overcharges similarly reflect a shocking failure of oversight by 

fund managers and directors. Commission overcharges, late trading, stale pricing, and illegal market timing can and will happen 

and probably continue to happen, even in an ideal compliance environment. Fund directors and managers cannot and should not be 

held accountable for individual instances of fraud. But the extraordinary pervasiveness of these frauds demonstrates that the problem is that the compliance environment in much of the fund industry has become corrupted. The scope of these frauds could not have 

been realized if fund directors and managers had ensured that procedures were in place that were reasonably designed to detect and 

prevent these frauds and that periodic spot checks were conducted 

to ensure the procedures were working. 

When alleged frauds such as these show a systemic failure of 

compliance, structural reform is necessary. It is not enough to 

change the rules when the problem is that existing rules were routinely ignored. The oversight system for mutual funds must be addressed. 

Toward that end, I propose that Congress create a mutual fund 

oversight board to supplement the SEC’s oversight of the fund industry. The Board would have examination and enforcement authority over fund boards. It would be financed from assessments on 

fund assets and appointed by the SEC. 

Americans are increasingly being expected to prepare for their 

retirement security on their own. But if their investments are simply going to be lost to fraud, in some cases perpetrated by the very 

persons to whom they have entrusted their financial futures, they 

will naturally turn away from our markets with potentially disastrous consequences for their retirement security and this country’s 

economic future. I strongly recommend that Congress take strong 

steps to restore America’s faith in the fund industry. 

42

1The prepared statement of Mr. Fink appears in the Appendix on page 186. 

Thank you again for the opportunity to appear before you today, 

and I am happy to answer any questions you might have. 

Senator FITZGERALD. Thank you. Mr. Fink. 

TESTIMONY OF MATTHEW P. FINK,1 PRESIDENT, INVESTMENT 

COMPANY INSTITUTE 

Mr. FINK. Thank you, Mr. Chairman. Like many of you here 

today and the witnesses that preceded me, I am outraged at the 

shocking betrayal of trust exhibited by some firms and people in 

our industry. 

As you said, Mr. Chairman, I have been at the institute for 32 

years. Mr. Bogle, who was one of the people who hired me 32 years 

ago, I love the mutual fund industry. And in virtually every discussion I have had over those three decades with Members of Congress and regulators and the media, when asked why the mutual 

fund industry has been so successful, I have attributed it largely 

to what Mr. Bullard just said: It has had a pretty scandal-free 

record because it has been committed to integrity. 

The investigations raise very serious questions about that integrity. I can assure you that I and the fund leaders are totally committed to answering every one of those questions. We want to rebuild trust, renew public confidence, and reinforce our history of 

putting the interests of fund shareholders first. This is because it 

is the best way for the funds, many funds who are not involved in 

the investigations, to continue to serve their investors well and for 

those who are involved to turn around and embrace needed reforms. And I can assure you, Mr. Chairman, that as far as we are 

concerned, every type of reform is on the table for consideration. 

I think it is clear that action has to be taken in three areas: first, 

government officials must identify and sanction every single person 

or firm who violated the law; second, fund shareholders who were 

harmed must be made right; and, third, strong regulatory reforms 

must be put in place to make sure these abuses never happen 

again. 

Let me turn to the third area of regulatory reform. The SEC, as 

you heard this morning, has laid out a blueprint. In connection 

with this, last week the Investment Company Institute called for 

three actions in each of the three areas of major abuse: Late trading, short-term trading, and trading by insiders. 

First let me talk about late trading. Current law, as you have 

heard, requires that orders to buy or sell fund shares have to be 

placed by investors by 4 p.m. Some orders may not actually be received by the mutual fund until many hours later. For the large 

number of transactions, 90 percent, that do not go directly to the 

fund but come through brokers or 401(k) plans or other intermediaries, the fund gaining assurance that the orders were placed 

before 4 p.m. is very difficult and, in fact, in many cases is impossible. Therefore, our recommendation is designed to solve this problem. 

We have called upon the SEC to require that all orders must be 

received by the fund itself by 4 p.m. This is very tough medicine, 

Mr. Chairman. Longstanding business practices will have to 

43

change. Millions of shareholders, thousands of brokers, banks, 

401(k) plans, and other intermediaries will be affected. And hundreds of fund companies will be affected. Nevertheless, we urge the 

SEC to move as quickly as possible, given the practical changes of 

implementing this scheme. 

My chairman, Paul Haaga, has stated that the 4 p.m. deadline 

‘‘represents all that can be done to slam the late trading window 

shut.’’ We are committed to keeping this window shut and locked 

permanently. 

The second area is abusive short-term trading, market timing. 

Chairman Donaldson has outlined ways to address these concerns. 

While some funds had policies and disclosure to discourage market 

timing, they, in fact, applied those policies unfairly or inconsistently, to say the least. And we endorse all of Chairman Donaldson’s 

plan. 

We have also concluded that on top of that, a substantial new 

regulatory requirement is needed. In fact, about the same day Mr. 

Bogle came out with the same type of plan. Mutual funds face 

great difficulty in enforcing their policies against late trading because for many accounts—and I cannot give you an estimate, but 

I would say perhaps 30 percent of fund assets—the shareholder’s 

account is not with the fund. The fund does not even know his or 

her name. It is with a broker, bank, 401(k) plan, a so-called omnibus account. There we only know the omnibus account name. We 

do not know anything about the individual shareholders or their 

transactions. Therefore, the funds cannot easily, or it may be impossible for them to enforce, their bans on short-term trading. 

Therefore, we recommend that the SEC require virtually all funds 

in this country to impose a 2 percent redemption fee on any sale 

of fund shares for 5 days following purchase. I think Mr. Bogle recommended a 30-day window, but it is the same type of idea. 

A standard industry-wide requirement like this could help intermediaries police their accounts. And I also want to make it clear 

that 100 percent of the proceeds of the redemption fee goes to the 

fund and its long-term shareholders, not to the fund’s management 

or the intermediaries. 

Let me just talk about the last and I think the most shocking 

issue: Abuse of trading by fund insiders. Last week, we learned of 

allegations that some fund managers have themselves engaged in 

short-term trading in their own funds. This is totally abhorrent. 

We support any steps necessary to make it clear that this is illegal. 

Moreover, we have called upon our members to amend their existing codes of ethics. 

Back in 1994, there was a scandal, smaller than the current one, 

where people who worked at mutual funds were buying stocks or 

bonds in front of their funds or possibly in front of their funds, and 

the industry came out with very tough procedures, best practices, 

to stop that. It included, for example, Mr. Chairman, any gains 

anybody who worked for a mutual fund made on a trade within 60 

days, even if the fund never thought about buying or selling that 

security, would have to be disgorged—reporting, post-trade monitoring, prior clearance, a whole bunch of controls. We understand 

both from the mutual funds and from the regulators this seems to 

have stamped out insider bad trading, short-term trading in stocks 

44

and bonds. Nobody thought at the time, frankly, to cover mutual 

fund shares. Everybody thought it would be a good idea for the 

fund managers to eat their own cooking and invest in their funds. 

We think these codes ought to be extended appropriately to cover 

trading in mutual fund shares. 

Let me just conclude, Mr. Chairman. It is also clear, as all the 

witnesses have said, that broader reforms are needed. We can address these three existing ones, but we do not want to be back here 

addressing a fourth one next year or 2 years from now. It is clear 

to me we need strong compliance systems and far better mechanisms for fund directors to determine that those compliance systems are working, not just in late trading and market timing but 

in all areas. 

The SEC recently issued a major rule proposal in this area, and 

we urge its adoption as swiftly as possible. We are also open to 

many of the measures that have been discussed today. I probably 

heard 20 or 30. And I have a feeling that if you took all the witnesses—government, industry, industry critics, etc.—there is probably 70 or 80 percent agreement among all that list. There will be 

differences of opinion, but I think there is general agreement. 

Mr. Chairman, in conclusion, I recently announced—I might say 

before the scandal—that I would be retiring after 32 years. And I 

promise with all of my heart to every member of this Subcommittee, all the other government officials involved, and, above 

all, the Nation’s 95 million shareholders, that I personally will use 

all of my own energies during my remaining tenure to see that 

these abuses are stamped out and that necessary reforms are, in 

fact, put in place. Thank you. 

Senator FITZGERALD. Thank you very much, Mr. Fink. It is indeed an irony that you were hired 32 years ago by Mr. Bogle and 

here you wind up on the same——

Mr. FINK. Among others. I don’t think he wants to——

Senator FITZGERALD. Among others. [Laughter.] 

I am not quite sure how they ever made Mr. Bogle the president 

of the ICI, and I want to ask him about how the industry has 

changed over the years. 

You said in your testimony, Mr. Fink, that any and all reforms, 

including several of those discussed by the previous panel, are on 

the table and you are open to consider. Let’s talk about some of 

those reforms. 

Mr. FINK. Sure. 

Senator FITZGERALD. What about having an independent chairman of the board for the mutual fund, independent of the advisory 

firm? 

Mr. FINK. Well, I knew you would ask the difficult ones. If I said 

80, you are into the 20 percent. I have to say, factually, I am very 

worried about solutions that appear to do something and do not do 

anything. Of the four firms in Canary that Mr. Spitzer brought his 

first case against, two have independent chairs. Of the total of 

eight firms that have been named today, as the list has grown—

Alger, Alliance, Putnam, etc.—three of the eight have independent 

chairs. So I have a feeling——

Senator FITZGERALD. Do you think it is a problem with the definition of ‘‘independent?’’

45

Mr. FINK. No. These are truly independent. I think an independent chair does not make much difference, Mr. Chairman, and 

I will tell you why. Right now, by law, by SEC rule, you have to 

have a majority of independent directors. Industry best practices 

are two-thirds. Probably industry practice may be two-thirds or 

better, in fact, so those independent directors can choose whoever 

they want to be chair from among themselves. They can set the 

agenda. They can set priorities. And when I ask independent directors who I respect they want the management company person to 

stay as the chair. Why is that? Well, that job is largely administerial, organizational, agenda building. It is easier for the person 

who is there full-time to do that. They say we will make the big 

decisions, but we only come in once a month or once a quarter. So 

I think there is a practical issue. 

I would just be wary of something that sounds good. Only 20 percent of the industry have independent chairs now, and yet three of 

the eight cases have independent chairs and it has not been a cureall. So I guess in my own view, Mr. Chairman, I am skeptical. 

Senator FITZGERALD. Well, let me ask you this, Mr. Fink: Why 

is it that Vanguard is able to negotiate lower fees with its investment advisers than virtually all others. Does any other mutual 

fund have lower fees from their investment advisers than Vanguard? 

Mr. BOGLE. I think it is fair to say as a categorical that no other 

funds—there may be a single isolated fee here or there, but I would 

be astonished to see even one that pays lower advisory fees than 

Vanguard. 

Senator FITZGERALD. And you have set up Vanguard so that you 

have eliminated those conflicts between the director of the funds 

and vendors to the fund. 

Mr. BOGLE. Right. 

Senator FITZGERALD. Well, why is it that not one of the other 

8,600 mutual funds in this country is not able to negotiate the kind 

of fees that Mr. Bogle’s firm has? 

Mr. FINK. Well, I think Mr. Bogle put his finger on it. You have 

got to remember—and Jack can correct me—Vanguard was created 

with existing—a lot of money in existing funds that reorganized 

themselves to do this. And as Jack said, there is no profit motive, 

so it would not pay Senator Fitzgerald or Matt Fink to go out and 

start a fund company that way because we would not make any 

money at it. So you kind of need an existing body of assets and 

then, I don’t know, internalize, mutualize. It is an unusual thing. 

But that is unrelated to the independent chair issue, Mr. Chairman. 

I am simply saying that you could pick—we have 20 percent of 

the industry with independent chairs. I do not think their track 

record for compliance, ethics, is any better than the 80 percent 

without independent chairs. 

Senator FITZGERALD. Mr. Bogle, would you care to respond? 

Mr. BOGLE. Yes. First, let me say that Vanguard started with an existing asset base of around $1 billion, $1.4 billion, and so we did 

have an asset base on which to build this mutual structure. And 

I will say, Mr. Chairman, I do not expect anybody to start a mutual 

fund group, except sort of someone like me, without an idea of an 

46

entrepreneurial profit. But that should not go on forever. You 

know, a child becomes an adult, and when we leave the billion-dollar level and have scores of fund organizations that are running 

$10 and $20 and $100 billion, they ought to grow up and think 

about having an internally managed structure. 

It almost offends common sense to think a $200 billion aggregation of assets has to hire another company to run it. What sense 

would that make? 

Senator FITZGERALD. Well, let me ask you this: Are there any 

other truly mutual mutual funds? Vanguard is the only one. We do 

have mutual savings banks. We have credit unions. They are organized. They are not-for-profit. Theoretically, they should have better interest rates that they offer to the customers. I think what has 

happened in practice is they have not been able to run banks or 

savings and loans out of town because their service is not as good, 

probably because there is not the profit motive there. 

But what would be wrong if the government created a means to 

encourage the formation of more truly mutual mutual funds? 

Mr. BOGLE. I think public policy should work in the direction of 

requiring consideration of mutualization after a fund gets to a certain size. One way this industry has changed over the long span 

I have been in it was, when I came in it, all management companies were private companies. They were private partnerships or 

private corporations owned by the investment adviser, and the SEC 

successfully kept people from going public to capitalize their fiduciary office. The SEC lost a case in court in 1958. We now have 

many public companies. And we also have what is really harmful 

to the industry and to the shareholders, and that is, 36 of the 50 

largest fund organizations are giant financial conglomerates. And 

when a big conglomerate buys a mutual fund business for $2 billion, they say to whoever they get to run it for them, ‘‘We want 

$240 million a year of profit—that is a 12 percent return on their 

capital—and if you cannot get it, we will hire somebody who can 

get it.’’

So that conglomeratization has moved the management away 

from this closely held group out into this distant financial colossus. 

At that stage fund complexes, if they have an independent board 

and an independent staff, will be able to say, look, we are going 

to mutualize. 

Mr. FINK. Mr. Chairman, two things. Jack paints a golden age. 

Well, we would not have had the Investment Company Act in 1940, 

which is the toughest of Federal securities statutes, if bad stuff was 

not going on in the 1920’s and 1930’s by these wonderful non-conglomerate people. I mean, bad stuff was going on——

Senator FITZGERALD. We called them investment trusts in those 

days. 

Mr. FINK. Yes, investment trusts. 

Second, why does somebody start a mutual fund? I am XYZ, T. 

Rowe Price, Fidelity. I start it. I spend a lot of money to get it 

growing. I hope to make a lot of money in the future. I do not expect that my directors 5 years from now, unless I do something terribly wrong, are going to move it. It is my creation. And the investor does not expect it. When I invest in the T. Rowe Price X fund, 

47

I do not expect tomorrow they are going to move the management 

to Fidelity or Putnam or Strong. It is a different situation. 

If I can just say this, Mr. Chairman, the Investment Company 

Act was created, and the problems we face today are because there 

are inherent conflicts in managing other people’s money. No doubt 

about it. The Investment Company Act tried to put in checks and 

balances to address that. In 1970, before my time, Mr. Bogle 

worked on it. Congress made the only major amendments to the 

Act to increase those checks and balances. We may very well be at 

a point where more checks and balances ought to be considered. 

But I do not think we have moved from a golden age to an age of 

knaves. There has always been a problem. It takes different forms. 

And we all have to think about—the industry for its own well-keeping has to think about—how to do it. 

Senator FITZGERALD. Mr. Bullard. 

Mr. BULLARD. Mr. Chairman, it is important to remember that 

while Vanguard is the leader on cost, there are fund companies 

that are competing directly with Vanguard on cost and in some 

cases doing it very successfully. TIAA–CREF, USAA——

Senator FITZGERALD. Now, TIAA–CREF is someone——

Mr. BULLARD. It is a separate entity, but it is a nonprofit. 

Senator FITZGERALD. It is not-for-profit, right. Does anybody 

else——

Mr. BULLARD. Well, for example——

Senator FITZGERALD. Does any for-profit firm compete closely on 

cost? 

Mr. BULLARD. Yes, sir. In fact, the biggest threat to Vanguard 

right now is exchange-traded funds, which are consistently offered 

by for-profit entities, and most people believe Vanguard missed a 

great opportunity to reduce its expense ratios that are now being 

undercut by those funds being offered by Barclay’s Global. 

And I also might add, the largest fund complexes generally correlate fairly consistently with lower costs, with Fidelity, Vanguard, 

American Funds, and T. Rowe Price. 

Senator FITZGERALD. The exchange-traded funds do in general 

have lower costs. Is that correct? 

Mr. BULLARD. Yes, they have lower costs with the same indexed 

funds than those offered by Vanguard. 

Senator FITZGERALD. Vanguard offers an exchange-traded fund. 

Mr. BOGLE. We do. Let me be clear on this. First, nobody competes with us on cost, Mr. Bullard notwithstanding. I mean, TIAA’s 

costs are about 10 or 15 percent higher; USAA’s are probably 100 

percent higher; Fidelity’s are 200 to 300 percent higher. So no one 

competes there with really rock-bottom costs. 

The trick of the ETFs, the exchange-traded funds, is all the costs 

of administration are basically thrown over to the marketplace, so 

people pay for them with their brokerage commissions and things 

of that nature. We have an ETF owning the total stock market 

index. We can run that for—I believe the number is 12 basis 

points, where the fund itself when we run is 15 to 20 basis points. 

So the differences are small but they are there. So we are in the 

business. No one is going to take that business away. 

Senator FITZGERALD. While we are talking about fees, what 

about enhanced disclosure of fees? Is it not true, Mr. Fink, that 

48

small differences in fees, in management fees and other fees, 

charged to a mutual fund can over time result in very big differences? 

Mr. FINK. I could not agree more, and the SEC has issued—the 

debate here is which way to enhance fee disclosure, generally. The 

SEC has issued a proposal that the annual report you get and the 

semiannual report—you get a report twice a year—would tell you 

at the beginning of the period if you had $10,000 invested what the 

$10,000 would be worth at the end of the period and what the expense—what your pro rata share of the expense would be. 

Senator FITZGERALD. Does that SEC regulation require every single expense be included in the calculation? 

Mr. FINK. We have to define ‘‘expense.’’ The ongoing operating 

expenses, we get back to an issue with Mr. Bullard whether you 

can put—and maybe Mr. Bogle. Brokerage commissions and trading costs are not in there because they are generally hard—they 

are not ongoing expenses. 

Senator FITZGERALD. Well, aren’t we deceiving an investor in a 

fund that allows a lot of churning and market timing if we are not 

making some attempt to quantify how they are being——

Mr. FINK. I am all for an attempt to quantify, but I would not 

put it in the expense ratio. 

Senator FITZGERALD. You are offering an attempt to quantify. 

The ICI would go——

Mr. FINK. Yes. 

Senator FITZGERALD [continuing]. Along with that. 

Mr. FINK. Yes. 

Senator FITZGERALD. Mr. Bogle, would you like to address what 

fees are not disclosed in the required disclosures that the SEC 

mandates in the prospectuses? 

Mr. BOGLE. Yes, I would like to at least make this one comment. 

The SEC and the ICI seem to have come to agreement that you can 

multiply $10,000 by the fund’s expense ratio to get the amount of 

dollars that would be involved. But they do not seem to be able to 

multiply the actual value of your account times that expense ratio. 

I find that absolutely astonishing in this technological age. It is 

one simple multiplication that the computer can do to give you the 

dollar cost number you want. So I do not understand what is going 

on over in this negotiation. 

Senator FITZGERALD. I want to make sure I understand this. Are 

you recommending a change to the SEC disclosure requirements? 

Instead of having them pick $10,000, you are recommending that 

they pick what? 

Mr. BOGLE. The asset value of your account at year-end. Multiply 

that by the existing expense ratio. 

Now, I would not yet go——

Senator FITZGERALD. Does the expense ratio encompass all expenses? 

Mr. BOGLE. No. That is just the fund expenses, which are essentially management fees and other operating expenses. 

Senator FITZGERALD. What are the other expenses? 

Mr. BOGLE. The other expenses are—well, they are quite numerous. One is portfolio turnover costs, which I have a very low estimate of, much lower than most people. I put that in at about 8 perVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00052 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
49

cent—8/10s of 1 percent, excuse me. So you would add that, for example, to the 1.6 average expense ratio, and that would get you to 

2.4 percent. 

Most funds have sales charges. If you amortize them over time, 

it is probably another 40 basis points, something like that. There 

are out-of-pocket costs. There are opportunity costs. Most funds are 

not fully invested so you pay an opportunity cost, that being the 

difference between long-term stock market returns and, say, money 

market returns, which comes to around another 30 basis points. 

So if one wants to think that mutual funds cost around 3 percent 

a year, one would not be far off. The fact is, Mr. Chairman, that 

we have done the study of fund performance since 1984, and the 

average fund has turned in a 9.3 percent annual return while the 

stock market has turned in a 12.2 percent annual return. That 

happens to be a 2.9 percent percentage point difference. 

And if I may expand on that, we have also found out the average 

fund investor during that period has earned a return of just 2.6 

percent, which I believe to be substantially overstated. That is for 

another day. 

Senator FITZGERALD. So we are missing 7 percent somewhere. 

Mr. BOGLE. Yes, somewhere along the way, and——

Senator FITZGERALD. Is that part of what I referred to in my 

opening statement as the skim? Was that all skimmed off? 

Mr. BOGLE. Well, actually, that is not the skim. That is the net 

result of an industry that used to sell what we made becoming an 

industry that makes what will sell, and that is, we market funds, 

technology funds, right at the high of the market. The money pours 

into them, and then it starts to pour out when it goes down. Even 

at the high, the money is pouring out of value funds, let’s call them 

old economy funds, into new economy funds. And investors have 

paid a huge penalty for that, partly, in fairness, their own fault, 

their own greed, probably their own jealousy of their neighbor. But 

the industry brings out those funds, promotes them, advertises 

them, and if you look at the March 2000 issue of Money Magazine, 

44 mutual funds were advertising their performance there, and 

they were offering to the investment public, believe this or not, Mr. 

Chairman, an average return over the previous year of plus 85.6 

percent, come and get it. But, of course, nobody got it. The market 

went down and they lost their money. 

Senator FITZGERALD. Mr. Fink, what about Mr. Bogle’s suggestion that in the prospectus, in addition to the expenses that are 

now required to be disclosed and netted out in calculating the return over the years, what if we add portfolio turnover costs, sales 

charges, out-of-pocket costs, and opportunity costs? 

Mr. FINK. A lot of them are in there now. At the front of every 

prospectus is a fee table that lists the operating expenses that the 

fund pays. 

Senator FITZGERALD. Are they in a graph? Are they in a bar 

graph? 

Mr. FINK. The opportunity costs, I want to be clear, some are in, 

some are not, because opportunity cost experts do not know how to 

capture that. There is a debate, to be fair about that. 

But 90 percent, I think to be fair, of what Mr. Bogle listed is in the prospectus fee table, and then it tells you, if you had $10,000 

50

invested for 1 year, 3 years, 5 years, exactly how much you would 

have paid out from those expenses. 

Senator FITZGERALD. So you have no trouble with disclosing all 

those costs and putting them in the graph? 

Mr. FINK. Some of the opportunity costs, I don’t——

Senator FITZGERALD. Except for maybe opportunity costs. 

Mr. FINK. Maybe one other, but, yes, no problem at all. 

Senator FITZGERALD. You have no problem if we require all of 

those expenses to be put in the calculation that is used to derive 

the graphs? 

Mr. FINK. I think I am right. Yes, I think so. 

Senator FITZGERALD. OK. You think so? 

Mr. FINK. I don’t know if I am missing something. That is all. 

Mr. BOGLE. You are not missing anything. 

Senator FITZGERALD. Senator Akaka. 

Mr. BOGLE. We have a new convert. 

Senator AKAKA. Thank you very much, Mr. Chairman. 

I want to shift the discussion a little bit. We have been talking 

about management and I want to shift more towards disclosure 

and particularly shift to information. I want to know what is the 

most useful and understandable relevant information that investors need to have to make sound financial decisions prior to purchasing mutual fund shares. I would like to move into that. As part 

of that discussion, I want to talk about mutual fund advertising 

since that is where many investors learn about funds. 

Mr. Bogle, what is your evaluation of mutual fund advertising? 

Do you believe that it is misleading to investors, and what needs 

to be done to prevent investors from being misled by advertisements? 

Mr. BOGLE. The first thing, and I did not always feel this way, 

but we live and learn. I believe that mutual fund performance advertising is inherently misleading on the face of it. We get this free 

shot. When times are good, we advertise very high returns. When 

times are bad, we either advertise nothing or we advertise our 

bond funds. The record is very clear on that. It is opportunistic, it 

is overly zealous, and it is inherently misleading. 

So I would say you cannot show performance numbers, and when 

I started Vanguard, I said we will never advertise a performance 

number, nor ever have we. So that is what should not be shown. 

What should investors think about? Investors should just simply 

understand that active management is in many respects a charade, 

that all mutual fund active managers end up being average. How 

could it be otherwise? And, therefore, they lose the market by the 

amount of costs. So investors ought to think first about how diversified is the fund and shouldn’t I just own the entire stock market 

rather than trying to pick a manager. 

Second, it is so important that they understand costs, that is 

right up there after diversification. 

Third, they ought to look at fund portfolio turnover. There is direct correlation not only between cost and investment returns, but 

between level of turnover in investment returns. I mean, it cannot 

be more obvious, and if you look in my written statement, you will 

see that if you combine those two costs, the low-cost quartile of 

funds does better than the high-cost quartile of funds by 3.5 perVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00054 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
51

centage points every year. And you can put that in every one of the 

Morningstar nine boxes. The pattern is unmistakable. The higher 

the turnover, the higher the costs, the worse the returns investors 

get. If we could talk investors out of looking at past performance, 

that would be a good thing. 

If we could talk them out of buying specialty funds and sector 

funds—they are always doing it after they turn in good performance. Investing is actually a matter of great simplicity. Get the diversification as wide as you can, the cost as low as you can, and 

close your eyes and hold on for the rough ride that common stocks 

have been giving investors since the beginning of time. So my first 

rule is: Don’t do something, just stand there. And my second rule 

is: Don’t peak, never look. And you’ll be fine when you retire if you 

follow those rules. 

Senator AKAKA. Thank you, Mr. Bogle. Mr. Fink, do you believe 

that brokers should be required to disclose in writing to those who 

purchase mutual company shares the amount of compensation the 

broker will receive as a result of the transactions? If so, why? 

Mr. FINK. We have called, I think beginning in 1995, for brokers 

to——

Senator FITZGERALD. If I could just interject for a moment, Mr. 

Bogle has to leave now, and I want to thank Mr. Bogle for coming 

here today. He has honored us by his presence. We thank you for 

the good work you have done over your illustrious career, and I 

hope to stay in touch with you as we work through some reforms 

that you have been arguing for for years. 

Thank you so much for being here. 

Mr. BOGLE. I would be glad to help, Mr. Chairman, in any way 

that is within my power. Thank you, sir. 

Senator FITZGERALD. Many thanks. 

Mr. Fink, I am sorry for that. 

Mr. FINK. First of all, Mr. Akaka, your question is a good one because I ought to point out, 90 percent of funds are not bought directly as in Vanguard. Ninety percent of people buy through a 

broker, a bank, a financial adviser, or 401(k) plan. So the amount 

of people who look at an advertisement right away for a prospectus 

is a very small sliver, just to put it in context. 

Yes, the broker should disclose if he is getting special compensation for shelf space for featuring one fund over another. Now, it 

may be hard to do an exact dollar amount because the arrangements don’t run that way. Some brokerage firm will say pay us $1 

million this quarter, we will feature your fund. It would be hard 

for the broker, that individual broker, to explain what he or she is 

getting. It’s maybe nothing. But there ought to be disclosure if the 

broker is being specially compensated, yes. 

Senator AKAKA. Mr. Ballard, which is the more accurate indicator of transaction costs: Portfolio turnover or brokerage commissions, and why? 

Mr. BULLARD. I am aware of only one academic study that actually looks at the correlation between actual commissions and turnover, and that concluded that there is not a very strong correlation 

between turnover and commissions. And, in fact, the expense ratio 

itself, which does not include commissions, is a stronger indicator. 

So in a choice between the two, at least to the extent we have some 

52

academic literature on it, the sign is that turnover ratios are not 

a strong indicator. 

In addition to that, I would say that when you have the number 

available itself, there really is not a good argument for using a 

proxy for that number. We know the dollar amount of commissions 

being paid by funds. There is no excuse for not immediately incorporating that into the expense ratio. 

And to answer the other part of your question—what are the 

other components of portfolio transaction costs?—they are generally 

considered to be four: Commissions, which are dollar amounts that 

all agree are generally objective; two other areas, market impact—

that is the actual impact on the price of a security caused by the 

fund trading it—is another cost; a third cost is spread impact—that 

is the amount of the spread between the bid and the ask price that 

is paid by a fund every time it trades; and then, finally, what you 

were talking about before, which are opportunity costs, which there 

is general agreement are the most difficult to measure. 

As a general matter, fund directors are responsible for reviewing 

the execution obtained by fund managers, and they are legally required to consider commissions, market impact, and spread costs. 

So they are being objectively quantified and being considered by directors. I don’t know if there are any who are looking at opportunity costs, and that may be something that is too subjective to 

incorporate in that number. But at a minimum, those three elements—commissions, market impact, and spread—should certainly 

be included in an objective amount that, albeit not perfect, certainly is better than leaving investors in the dark about what may 

be a fund’s single largest expense. 

Senator AKAKA. Thank you. This is a question that either one of 

you can answer. There have been some, including Secretary Galvin 

on the previous panel, who have called for banning the use of soft 

dollars. Do you believe soft dollars should be banned and why? Mr. 

Fink please respond first. 

Mr. FINK. OK. I want to make it clear. It was Congress who 

blessed soft dollars in 1974 in Section 28(e)—maybe I shouldn’t say 

that with the Senators sitting here, but Congress did it in 1974 in 

Section 28(e) of the 1934 Act. All advisers, mutual funds, pension 

funds, public pension funds, charities, endowments, all managers—

this is not a uniquely mutual fund problem. We are considering in 

our own office a position on total abolition, but there is an easier 

first step to take that we are also considering. 

For many years after 1974, the SEC took a very restrictive reading of what were legitimate soft dollars. There had to be research 

produced by the brokerage firm that you did the execution with. In 

1978, they came out with a much broader interpretation which allows people to buy all kinds of stuff. So an easy remedy, barring 

trying to get Congress to repeal it, would be to cut it back to 1978, 

not just for mutual funds but for all users of soft dollars. 

One other thing, Senator Akaka. You read before some of the 

uses people were making based on the SEC report. That report I 

think is 4 years old. It looked at both mutual funds and private 

money managers. It found a series of abuses in private money 

managers. I hold my breath these days, but I think it did not find 

a single abuse in the mutual fund area. So I am saying I think the 

53

funds have been pretty good, at least the last check, living up to 

the current rules. But an easy thing for the SEC to do, an easier 

thing to do would be to cut it back, cut the permissible usage back, 

and then think about abolition. 

Senator AKAKA. Mr. Bullard, what are your comments on whether the use of soft dollars should be banned? 

Mr. BULLARD. Certainly, Senator. I would agree with Mr. Fink’s 

recommendation, but I think there is a broader question involved. 

And as a general matter, my view is that you should leave, when 

you can, these questions to the market to decide. If the market believes that a fund manager who pays 6 cents a share for a trade 

and gets research is making efficient use of those dollars, then that 

is something that we should be able to live with. If the market decides they want the fund manager to spend 2 cents a share and not 

get research, we should also be able to live with that. 

The problem, though, is that the market cannot make a decision. 

The market is not being told in any way the actual cost, that actually 4 cents a share more that is being paid for the fund using soft 

dollars. So before we get to the point of deciding whether to abolish 

soft dollars, I would rather have them disclosed. They are included 

in commissions. Include them in the expense ratio and let the market decide. And if it wants to punish funds that use soft dollars, 

so be it. 

But as Mr. Fink pointed out, they are used very widely. They are 

used by Vanguard. Vanguard uses its soft-dollar payments essentially to reduce its custodial fees, generally. 

So this is a practice that isn’t inherently abusive. It may drive 

up costs, but I think principally because it is not fully disclosed and 

transparent. 

Senator AKAKA. Thank you gentlemen for your responses. My 

time has expired, Mr. Chairman. 

Senator FITZGERALD. Mr. Bullard, I would like to ask you about 

a proposal I have recommended, and I think Attorney General 

Spitzer also recommended it in his opening statement. We recommend that mutual fund directors be required to competitively 

bid out their management, their investment management contracts. What do you think of that proposal? 

Mr. BULLARD. I think that proposal would substantially change 

the mutual fund industry as we know it in ways that we could not 

predict. As a general matter, if you have good disclosure of fees and 

you have standardized disclosure of performance, again, I would 

leave it to the market to decide which funds they want to invest 

in. 

Essentially, we have a board of directors who sits in a sense second-guessing judgments made by shareholders to which manager 

they want and what expense ratio they want to pay. And in a best 

world, I would like to leave that decision to shareholders and have 

fund directors applying an ultimate fiduciary test to make sure as 

a back-up that those fees are not excessive and that those fund 

managers are complying with the law. 

So I would not recommend requiring that they bid out those contracts because essentially it is not clear to me what decision the 

shareholder would be making anymore if they buy a Fidelity fund 

and——

54

Senator FITZGERALD. Do you advise any mutual funds? 

Mr. BULLARD. Do I? No. 

Senator FITZGERALD. Mr. Fink, what do you think about requiring that the investment advisory——

Mr. FINK. I think it is contrary to the factual situation. I decide—Mr. Bogle knows me and I decide to buy the Vanguard XYZ 

fund because it is managed by Vanguard. I do not expect tomorrow 

that the Vanguard board says, gee, we are leaving for Fidelity or 

T. Rowe Price or Putnam or Strong. 

You have to remember, people created these funds as products. 

There are conflicts in running it. That is why you have independent directors. But the fund is not a freestanding entity that 

every year just decides what it wants to do. The manager created 

the fund as a product. We ought to control the manager, disclosure, 

conflict rules, but it would make no sense to put the contract out 

for bid. I am a consumer. I am buying a Ford. I do not expect tomorrow that magically it is going to be a Chevrolet. I mean, it is 

a funny kind of thing. 

Senator FITZGERALD. Do the funds that have the lowest fees 

seem to attract the most funds in the marketplace? 

Mr. FINK. Generally, yes. I don’t know if I can phrase that right. 

Not perfectly, but the last time we looked, 77 percent of shareholder accounts that we could identify were in funds at the lower 

half of the expense thing. Now, that is probably because over time 

expense and performance have some relationship. So generally, yes. 

Fidelity is the largest fund. Vanguard, which is the cheapest, is the 

second largest. Not perfectly, but in general, yes. 

Now, I would make another point if I can. This gets confusing. 

We keep talking about the 10 percent of people who are doing their 

own, sitting in their living room, reading Mr. Bullard, reading Mr. 

Bogle’s editorials, reading Morningstar. Ninety percent of people do 

not act like that. They rely on their broker, financial planner, etc., 

and their funds are going to be more costly than the direct funds 

because they have costs relating to distribution. 

Senator FITZGERALD. And most of them do not know that their 

broker is getting a 12b–1 fee for steering them to a fund, do they? 

Mr. FINK. That I do not know. 

Senator FITZGERALD. Do you have any problem if the brokers are 

required to send a written confirmation to the person they have 

steered into a mutual fund that that broker is getting 12b–1 fees? 

Mr. FINK. I think it is proposed now, but not required. Am I 

right, 12b–1 is in the prospectus? 

Senator FITZGERALD. It is in the prospectus, but I am saying——

Mr. FINK. Not confirmation, no. 

Senator FITZGERALD. I have recommended that there be a written statement sent from the broker to the customer who is being 

steered into a fund that this broker is getting a fee for steering the 

person. 

Mr. FINK. That is——

Senator FITZGERALD. I do not know how many people are going 

to get that from reading the prospectus, but they would probably 

have to have a law degree and have had a securities law course, 

and particularly a securities law course that focused on the InvestVerDate 0ct 09 2002 12:26 Apr 06, 2004 Jkt 091038 PO 00000 Frm 00058 Fmt 6633 Sfmt 6633 C:\DOCS\91038.TXT SAFFAIRS PsN: PHOGAN
55

ment Company Act to really glean everything that could be gleaned 

out of there. 

Mr. BULLARD. That is right, Senator. You really hit on the key 

division between types of disclosure. There is the prospectus, which 

really gets to how much is this investment going to cost me. But 

what you are getting at is a different kind of disclosure, and that 

is, what are the incentives that broker has for pushing this fund? 

If you buy IBM stock or Dell or some other company, you are required to get a confirmation, and it tells you how much your broker 

got paid. Mutual funds are virtually the only kind of security that 

are excepted from that because of an SEC no-action letter issued 

more than 20 years ago. 

Mr. FINK. I think the SEC is revisiting that, by the way, if I am 

right, as part of the break points. 

Mr. BULLARD. They have been reviewing it for about 4 years. 

That is true. 

Senator FITZGERALD. Mr. Fink, in my opening statement I said 

that Congress had, in effect, turbocharged the growth of the mutual fund industry by setting up all sorts of vehicles for tax-deferred savings, 401(k) plans, IRAs, multiple types of IRAs, Keogh 

plans, and college loan accounts. Is it not true that Congress’ actions in that regard have benefited the growth of the mutual fund 

industry? 

Mr. FINK. Tremendously, but to put the numbers on the table, 

if you took 401(k) and all defined contribution plans, yes. The answer is yes. But I do not want to exaggerate it. If you took all the 

401(k), 457, 403(b), all the DC plans, mutual funds are about 30 

percent. Investments are going 70 percent into something else; 

IRAs, individual recruitment accounts of all types—Roth IRA, 

back-end IRA, front-end IRA, etc.—with 40 percent. So, yes, it has 

been a big boost for the fund industry, but it has been a big boost 

for insurance annuities, bank collective funds, company stock, you 

name it. We are not the only beneficiary. That is all I want to say. 

Senator FITZGERALD. Well, given that Congress has set up such 

vehicles that benefit and facilitate the growth of the mutual fund 

industry, wouldn’t it be reasonable to expect, since Congress has 

funneled so much of America’s household, college, and recruitment 

savings to your industry, that we have some really pretty tough 

safeguards, tougher than are now on the books, to guard all that 

savings? 

Mr. FINK. Absolutely, yes. 

Senator FITZGERALD. And you are prepared to work with this 

Subcommittee and others to address some of the reforms, and you 

understand, too, that if trust in the industry is eroded over time, 

it will erode the industry’s growth? 

Mr. FINK. Oh, yes. This is not beneficent on the industry. The industry realizes that in a product that does not have FDIC insurance or state insurance funds, we are totally reliant on public confidence. And anything like these scandals that erodes it is terrible 

for the industry itself. And, in fact, Mr. Baker’s bill, as it came out 

of the Committee, we were fine with. I think there the debate was 

not the terms of that bill, but whether it could be done better 

through Congress or the SEC. I mean, that was part of the debate. 

56

Yes, we are open to reforms. I said earlier—I tried to keep a running list when I was sitting there of the 20 things I heard. I think 

75 or 80 percent are probably fine. On the rest, there probably is 

as much dispute among the critics as among the industry and the 

critics, I think. 

Senator FITZGERALD. I wonder if you agree with those who question whether directors can be both insiders of the investment advisory company and directors of the fund? I believe that it is difficult 

for human beings to serve two masters. 

Mr. FINK. I looked it up. It is from St. Matthew, oddly enough. 

[Laughter.] 

But if I can, yes, no one can serve two masters. So the Investment Company Act does two things about this. One is it says that, 

through SEC rules, a majority have to be independent. And whenever there is a conflict issue—if you think of yourself at a board 

meeting, 12 issues, probably 10 or 11 do not present a conflict between the fund and the adviser, between the shareholders and the 

adviser. The law requires in areas like contract renewal, on the advisory contract, the underwriting contract, 12b–1, etc., that there 

you need a separate vote of the independent directors. So in cases 

where there is conflict, you take the interested people out. They do 

not count. 

Senator FITZGERALD. How come so few of the funds are competitively bidding out their investment advisers? 

Mr. FINK. I think for the reason that Mr. Bullard said. When 

someone buys a share of Vanguard prime cap fund, I am really 

buying Vanguard management. I do not expect the directors tomorrow to move me to Fidelity or T. Rowe Price. 

Senator FITZGERALD. But isn’t your clientele here somewhat captive? They have a 401(k), and money is automatically funneled into 

it every month. So isn’t some of this money kind of lazy? It does 

not investigate as it ought to investigate, and so maybe we have 

to have special rules here in Congress? 

Mr. FINK. I think you need special rules for mutual funds, yes, 

for collective vehicles where there are millions of people, they have 

to be represented by directors, there have to be rules on conflicts. 

Senator FITZGERALD. So why not require competitive bidding of 

investment managers? 

Mr. FINK. Just for the reason I stated. I think even in the typical 

401(k) plan, or a lot of the big ones, you have Fidelity, Vanguard, 

T. Rowe Price, and Putnam. So people can move around among 

them in those funds. 

Mr. BULLARD. Chairman Fitzgerald, I think it is possible that in 

the long run that step may be needed. But one step that I think 

we have never really tried is to light a hot enough fire under fund 

directors so they would negotiate hard over the fees that are currently in place. And it is clear, as indicated by these massive compliance breakdowns, they are not doing that. 

Senator FITZGERALD. Aren’t most fund directors often they are 

employees of the money manager? 

Mr. BULLARD. That is right. Many of them are. And what I would 

like to see is——

Senator FITZGERALD. Isn’t most of their annual income coming 

from the firm they would be negotiating with? 

57

Mr. BULLARD. That is exactly right. 

Senator FITZGERALD. So how can you have a negotiation with 

yourself? 

Mr. BULLARD. Well, I would propose to have some source of an 

outside independent body setting out what the fiduciary standards 

are for reviewing advisory contracts, which currently does not exist 

and the SEC does not do. There are funds that have expense ratios 

that are 10 or 15 percent of assets, and the SEC has chosen never 

to bring an action against them for the director’s violation of fiduciary duty. 

Senator FITZGERALD. Ten or 15——

Mr. BULLARD. Ten of 15 percent. And the SEC has decided to 

completely——

Senator FITZGERALD. Can you name any names? 

Mr. BULLARD. If you go on Morningstar’s site, you will be able 

to run a check, and you will find tiny funds with 10 percent expense ratios. And if the SEC is not going to go after those funds, 

it is pretty hard to ask the fidelitys to negotiate fees separately. 

Senator FITZGERALD. Mr. Fink, a final question. 

Mr. FINK. Can I comment? 

Senator FITZGERALD. Yes, go ahead. 

Mr. FINK. When you are negotiating the contract—I happen to 

have my handy-dandy copy of the Investment Company Act. It says 

that the contract has to be approved by a majority of the directors 

who are not parties to such contract or affiliated parties to such 

contract, and they meet without the interested directors being 

there. So in the negotiation——

Senator FITZGERALD. Well, what do you think is wrong with the 

fund directors that Mr. Bullard referred to who agreed to an investment advisory contract that charges—did you say 10——

Mr. BULLARD. An expense ratio, not an advisory contract. 

Senator FITZGERALD. But that would include the——

Mr. BULLARD. That would include—the advisory contract might 

be 2 percent or 3 percent. 

Senator FITZGERALD. OK. 

Mr. FINK. They can be sued. They can be sued not only by the 

SEC but by any shareholder. Section 36(b) of the Investment Company Act gives an express Federal right of action for any fee that 

breaches a fiduciary duty or is unreasonable. 

Mr. BULLARD. The SEC has never sued such a fund. 

Senator FITZGERALD. But private lawsuits would be welcome in 

this regard? 

Mr. FINK. I do not know about welcome——

Mr. BULLARD. There are class actions all over——

Mr. FINK. There are a lot of them. 

Mr. BULLARD. There is no money in it. 

Senator FITZGERALD. There is no money in those suits? 

Mr. BULLARD. There is no money in suing a $10 million fund for 

charging a 15 percent expense ratio. 

Senator FITZGERALD. Final question. Attorney General Spitzer 

said that he wants to make sure that all the mutual funds that he 

has found in his investigation of the late trading and market timing disgorge all of the fees that they earned during the period that 

58

the illegal practices were going on. What is the Investment Company Institute’s position? 

Mr. FINK. I have no position on that. It seems to me that is between Mr. Spitzer and the defendants, sir. 

Senator FITZGERALD. OK. All right. Thank you both. Senator 

Akaka. 

Senator AKAKA. Thank you very much, Mr. Chairman. This hearing has been very helpful and it will help us craft the kind of bill 

that will help the people of our country. I want to thank our panelists for your responses. 

Thank you. 

Senator FITZGERALD. Thank you. You have both been terrific. We 

appreciate your patience. It has been a long morning and afternoon. Thank you very much. 

For your information, the hearing record will remain open until 

5 p.m. on Friday of this week in the event that other Senators 

would like to submit questions. And if there is no further business 

to come before this Subcommittee, this hearing is adjourned. 

[Whereupon, at 1:49 p.m., the Subcommittee was adjourned.] 

(59)

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